The Deleveraging of US Households (2009 3Q Flow of Funds Update)
(December 13, 2009)
Dear Subscribers and Readers,
Before we begin this weekend's commentary, I want to reiterate our mission of starting MarketThoughts.com. This mission is simple: Our goal has always been to provide our readers the best education and insights on what drives the financial markets and individual stocks – and helping you, our readers, to achieve your long-term financial or investment goals. We are not perfect – but we're strictly focused on this goal and this is the only motivation for us in the long-run. We strive to maintain our integrity and intellectual honesty by:
- Maintaining total transparency on our buy and sell signals of our DJIA Timing System;
- Not giving the investing public what they want, but what they need in order to invest successfully over the long-run. We don't pander to the public's insecurity and fear about investing; we also do not seek to provide false leadership to increase our membership;
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Gail Wynand, the newspaper magnate in Ayn Rand's novel “The Fountainhead,” built his media empire and rose to the upper echelons of power through pandering to the “lowest tastes of the crowd.” Despite his inherent brilliance, Wynand's philosophy on life requires him to suppress his brilliance and to relinquish his admiration of mankind's noblest achievements. He believes that originality and creativity has no place in the world – and that to simply survive – one must need to accumulate power through pandering to the mediocre standards of the crowd. Ultimately, this strategy backfires on Wynand – once he realizes that he really has no real power – and that simply giving what the crowd wants does not lead to long-term success.
We don't pretend to possess the brilliance to understand all the intricacies of the global macro economy or the global financial markets. But we do believe that life and investing is an ongoing learning process – and one must be honest with oneself and his/her subscribers in order to achieve true understanding and long-term outperformance. We do not allow the thinking of others to dominate our lives or writing.
Let us begin our commentary by reviewing our 9 most recent signals in our DJIA Timing System:
1st signal entered: 50% short position on October 4, 2007 at 13,956;
2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.
3rd signal entered: 50% long position on January 9, 2008 at 12,630;
4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;
5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;
6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 1,700.50 points as of Friday at the close.
7th signal entered: Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 1,391.50 points as of Friday at the close.
8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;
9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points.
Before we discuss the Federal Reserve's latest quarterly Flow of Funds report, I want to make a brief comment on the concept of “Peak Oil.” As discussed in our commentaries over the last 12 to 18 months, we believed that crude oil prices made a secular peak last July at $145 a barrel and that most likely, the price of WTI crude oil will trade in the $60 to $90 range over the next three to five years (with a 95% confidence interval). The literature surrounding “Peak Oil” is wide-ranging, but one should not necessarily associate a potential peak in oil supply (at this point, this is not imminent) with a spike in oil prices or a collapse of our modern-day economy.
What the “Peak Oil” crowd ignores is that even in the very short-term, crude oil supply is abundant and should serve all our needs easily over the next few years. For example, according to the Energy Information Administration (EIA), crude oil inventories in OECD countries stood at 2.77 billion barrels at the end of 3Q 2009, or 115 million barrels over the five-year average, as shown in the following chart. In addition, Chinese oil inventories (which are not part of the OECD) are also rumored to be bursting at their seams (if the Chinese continued to fill their inventories at an oil price of over $100 a barrel, there's no doubt that they are filling as much as they could with WTI oil at $69 a barrel):
More importantly, OPEC surplus oil production capacity remains at over 4 million barrels a day – the highest level since 2002 and over 1 million barrels higher than the 2.8 million barrel-per-day surplus capacity from 1998 to 2008 (as shown in the following chart):
OPEC surplus capacity is projected to rise by an additional 600,000 barrels a day in 2010, as more projects come online in Angola, Iraq, Qatar, and Saudi Arabia. Iraq's production is particularly worth tracking, given the years of underinvestment in its oil fields over the last few decades. Iraq's current production is approximately 2.5 million barrels per day, and is projected to rise to 2.8 million barrels per day sometime next year. Iraq's potential oil production is huge – forecasters are projecting 4 million barrels per day by 2015 and as much as 10 million barrels a day (assuming prices remain firm) in ten years.
On the demand side – while the ongoing industrialization of China will increase demand for fossil fuels – such fears of Chinese oil demand swamping supply are overblown. For example, the Chinese purchase of new automobiles is expected to surpass that of the US for the first time in history this year. The Chinese automobile fleet continues to grow by leaps and bounds – and yet, Chinese oil demand has remained stagnant over the last 12 to 18 months. There are several reasons for this, including: 1) Chinese public policy makers have made a conscious effort to reduce the “energy intensity” of many of its heavy industries by closing smaller and less efficient plants, 2) Chinese public policy makers raised fuel prices last year through a mechanism that aligns them with global market prices, and 3) Driving a car in congested cities such as Beijing and Shanghai isn't really that fun, especially since public transportation is more efficient (hence the purchase of an automobile is more of a status symbol for many Chinese families). Finally, with the ongoing breakthroughs in the commercialization of cellulosic ethanol (2012-2013 timeframe), more efficient biofuels (2015), and more efficient solar power panels, we assert that real energy prices made a significant peak during last year's summer.
Let us now discuss the 2Q 2009 Flow of Funds update that was published by the Federal Reserve last Thursday. The Federal Reserve's Flow of Funds is published on a quarterly basis; its goal is to track the nation's stock of assets, and fund flows for the latest quarter, as well as over the last year. Data is available for most statistics since 1952. One of the main themes that we have been tracking through the Flow of Funds information has been the concept of overleveraged US households, as well as their “new journey” as they actively deleverage and rebuild their balance sheets. In our June 14, 2009 commentary (“The Fed's 1Q 2009 Flow of Funds Update”), we discussed the fact that US households' asset-to-liability ratio (using the Fed's Flow of Funds data as of 1Q 2009) hit a new post WWII low, and that despite the rally in asset prices during the second quarter, it will take at least several years before US households will finish rebuilding their balance sheets. US households' balance sheets improved slightly over the last two quarters, rising by $2.3 trillion during 2Q (see our September 20, 2009 commentary) and $2.7 trillion during 3Q. As of the end of 3Q 2009, US households' balance sheets stood at $53.4 trillion, corresponding to an improvement in households' asset-to-liability ratio from 4.44 to 4.80 over the last two quarters. As depicted in the following chart showing US households' asset-to-liability ratio and absolute net worth, however, US households' net worth have a very long hill to climb before it can reach its prior peak levels, even assuming US housing have already bottomed:
Based on the above chart, US households are probably going to deleverage their balance sheets for another two to three years. Looking deeper into the data, however, it is interesting to see that US households' liabilities have only declined by $460.2 billion from its peak. This is interesting as global financial institutions have now written off more than $1 trillion from their mortgage holdings and as US consumer credit has grown by a minimal amount over the last 12 months. So why did US households' liabilities only dip by $460.2 billion from its peak? The likely answer is that the many US households who have seen their mortgages written down by financial institutions are still paying their mortgages (following “mark to market” rules and the lead of the structured finance indices). While this bodes well for the balance sheets of the US largest banks (whose portfolio are mostly in residential mortgage securities), it also means that the true deleveraging (and home foreclosures) is not yet over. That is, actual mortgage defaults will most likely stay elevated over the next 12 months.
Indeed, as we have already mentioned, the sector that needs the most deleveraging over the next decade is US housing. The following quarterly chart shows the growth in mortgage debt and “all other debt” (i.e. the growth in consumer debt excluding mortgage debt) relative to the growth of US household assets from 1Q 1952 to 3Q 2009. While Americans have indeed been “gorging” on credit, it seems that all this gorging has occurred in the mortgage markets over the last 20 or so years:
As mentioned on the above chart, for every percentage growth in assets that US households accumulated over the last 57 years, the growth of mortgage debt was 3.6 times as much, while the growth of “all other debts” (e.g. consumer credit, bank loans, margin loans, etc.). was “just” 2.1 times as much. Sure, a significant amount of this mortgage debt in recent years came in the form of home equity loans, much of which have gone into consumption spending such as home improvement spending, second or third automobiles, or large screen TVs (readers should not forget that some of these have also gone into “investments” such as education spending), but this does not change the fact that the vast majority of the deleveraging will occur in the US mortgage market. While the “coming of age” of the Y-gens (the offsprings of the baby boomers) should add an extra 100,000 to 150,000 households over the long-term over the next decade and thus should provide a “cushion” to the US housing market, US housing could easily underperform again as baby boomers liquidate their residential properties to pay for living expenses or to relocate to smaller or cheaper living areas. I expect most US regional housing markets to underperform other asset classes for the next 15 to 20 years (although assisted living properties should outperform).
Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2007 to the present:
For the week ending December 11, 2009, the Dow Industrials rose 82.60 points, while the Dow Transports declined 7.94 points. With the Dow Industrials and the Dow Transports having made concurrent highs just two weeks ago – combined with decent valuations, strong liquidity, and strong upside breadth/momentum – there is no question that the cyclical bull market that began in early March is intact. However, given the ongoing concerns about certain economies such as those of Spain, Greece, and Dubai, I expect the US stock market to continue to consolidate going into the end of this year, if not the early part of January (such a consolidation period would also be healthy for the market in the longer-run). We thus maintain our 100% long position in our DJIA Timing System.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators increased from a reading of 13.2% to 15.2% for the week ending December 11, 2009. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
The four-week MA of the combined Bulls-Bears% Differential ratios just hit a 25-month high and is now very overbought relative to its readings over the last two years. In addition, its relentless rise from early March suggests that individual investors have gotten too bullish, too quickly. Given the amount of cash on the sidelines, strong liquidity, and decent valuations, there is enough "pent-up demand" for a further rally, but probability suggests that the stock market will need to consolidate further before the rally can continue. In addition, both the Federal Reserve and the European Central Bank are indicating that monetary policy may be tightened by early next year (the second quarter for the Fed, and the first quarter for the ECB) - meaning that liquidity creation will be constrained in the short-run. For now, we will remain 100% long in our DJIA Timing System, as we believe the cyclical bull trend that began in early March remains intact.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market. Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:
For the week ending December 11th, the 20 DMA decreased slightly from 132.4 to 132.2, after hitting a fresh 6-month high of 137.6 the Tuesday before last. As mentioned on the above chart, the 20 DMA has now settled lower, although it remains overbought relative to its readings over the last two years. Combined with the overbought readings in our other sentiment indicators, probability suggests that the market will consolidate further before it can embark on a sustainable uptrend. In addition, the macroeconomic backdrop - specifically the ongoing troubles of Spain, Greece, and Dubai the European banking system, as well as the US commercial real estate market - is also suggestive of a further consolidation period for the stock market into the end of the year, if not the early part of January.
Conclusion: As we head into 2010 and as global surplus oil production capacity remains ample, the cult of “Peak Oil” will most likely be debunked. While the long-term supply picture remains murky, short-term supply remains ample. Combined with anemic growth in global crude oil demand (including Chinese demand) – as well as new fuel sources coming online over the next three to five years – my sense is that oil prices will likely be mired in the $60 to $90 a barrel range over the same timeframe. It is also difficult to get bullish on oil and other commodities in general as US households continue to deleverage. While I don't buy PIMCO's “New Normal” view of a ten-year deleveraging process, I do believe that US economic growth will remain below trend for the next few years (although US housing should remain challenged). Sometime in the 2012 to 2013 timeframe, I expect US economic growth to accelerate again – once US households have paid down a significant portion of their debts and as the next generation of energy, biotech, and nanotech comes online that will drive the next secular bull market in US stocks and Schumpeterian growth.
As for the US stock market, while many indicators suggest a consolidation period for the stock market into the end of the year – probability suggests that the cyclical bull market that began in early March is still intact. For us to turn very bearish on the market again (i.e. for us to enter into a short position in our DJIA Timing System just like we did in October 2007), many things would need to line up, including a potential fiscal policy mistake (i.e. higher taxes), economic policy mistake (i.e. major protectionist threats), or a monetary policy mistake (such as the failure of the ECB to assist the Euro Zone's banking system in raising capital). For now, our short-term belief is that the US stock market will be mired in a consolidation phase into the end of the year, if not the early part of January. We also remain bearish on the retail industry (as discussed in our commentary a month ago), as well as the major US casino operators. Subscribers please stay tuned.
Henry To, CFA