U.S. Household Sector Not as Bad Off as Commonly Believed

It is clear that the government is going to do whatever it takes, through monetary and fiscal policy, to break the recession and debt-deflation dynamics at work in the economy and the markets. The new Administration will implement a massive fiscal stimulus program, and the Federal Reserve, in addition to holding policy rates near zero for an extended period, will continue to pursue unconventional programs aimed at jump-starting credit markets and liquefying credit providers.

In short, the government is getting ready to prove the thesis articulated by Chairman Bernanke six years ago that deflation is reversible under a fiat (i.e. paper-based) money system, provided the government is sufficiently determined and creative. It is puzzling that so many seem to doubt that premise and are pricing assets as though the economy were headed into a protracted (i.e. multi-year) deflation.

It may take some time, but it seems clear that the government will create sufficient quantities of money to cause money to be worth substantially less in the years ahead. Cash (and Treasuries) may be king for the moment, but will prove to be poor investments in that environment. The pessimists, who today have the upper hand, believe that the economy is hopelessly trapped in a deflationary bust, but this is an overstatement of the debt problem. The worst excesses of the credit bubble were in the financial sector. We have all watched that spectacular collapse of leverage on Wall Street and are now in the process of rebuilding a sounder financial system.

However, the deflationists argue that the U.S. household sector, which is a far more important driver of economic activity, also grew hopelessly addicted to debt and are now caught in a terrible “liquidity trap.” This is an exaggeration, so I find myself in the unfamiliar position of arguing that the U.S. household sector, despite having just suffered an historic hit to net worth, is not nearly as bad off as is now commonly believed.

Consider two facts concerning leverage at the household level. First, the U.S. government publishes debt service coverage data for the household sector, including a statistic called the “financial obligations ratio,” which captures not just required payments on mortgage and consumer debt, but also automobile leases, homeowner’s insurance, and property tax payments. From 1980 to the present, for U.S. households in the aggregate, all of these obligations as a percentage of disposable income have grown from 13.8% to 17.5%. This is a significant increase, but hardly catastrophic. Many households locked in historically low long-term mortgage rates in the past decade and many households never took part in the debt binge at all.

Second, the bear market in the stock and real estate markets has caused U.S. household net worth to decline from a peak of approximately $58 trillion to an estimated current level of approximately $45 trillion. That is the largest hit in several decades, to be sure, but $45 trillion of net worth is still a VERY large number and helps to put the $14 trillion of current U.S. household debt in perspective. The greatest risk an investor faces at this point is how long and deep this recession will be. It may end up being the worst recession in the post World War II era. If that is the case, stock investors will have to deal with failed rallies and limited upside for a period of time. However, even in this scenario, it is likely that the November 20th price lows will hold because an outlook for significant further economic weakness is widely accepted and therefore likely reflected in market prices.

Alternatively, this recession may turn out to be not as bad as is currently feared, in which case a new cyclical bull market could get underway relatively soon. Whichever scenario unfolds, it is highly likely that long-term investors will be amply rewarded for holding and purchasing stocks at current depressed prices. Investors have endured one of the worst decades in history for stock market returns (a testament to how overvalued stocks became in the late 1990s and the dangers of debt bubbles).

From November 1998 to November 2008, the S&P 500 (SPY) has delivered a return of negative 0.9% per annum, representing a cumulative loss of 9%. The consolation for ten years of terrible stock market performance is that the next ten years are highly likely to be very rewarding. According to statistics compiled by the Leuthold Group, whenever trailing ten year annual returns have fallen to 1% or less (which has only happened following the great bear markets of the 1930s and the 1970s), the next ten years have produced an average cumulative return of 183%, and the worst subsequent ten year return was 101%.

Comments

[John Pseudonym:]

"We have all watched that spectacular collapse of leverage on Wall Street and are now in the process of rebuilding a sounder financial system"

Are we?

Is pumping a TRILLION(s) DOLLARS into failed institutions a method for building a "Sounder Financial System"?

From my perspective, that's an attempt to keep the old system alive; or to bring it back from the dead...

If we were really building a sound system, we would let the worst institutions fail and hand their assets over to best run banks.

Instead, we are propping up the losers with imaginary taxpayer money.

In doing so, we're building a bigger mess that will end with the world questioning the solvency of the US Government itself.

2008 Dec 10 11:23 AM

[The LFB:]

The consumer is devastated. Their most important assets-home and 401k, have been severely compromised at the same time their balance sheets were levered the most in history.

Just look today's oil inventory numbers-demand for finished products fell 6.1% from last year even with all the price declines.

The next ten years are highly likely to be very rewarding? If your grandchildren live to be 100 years old, they won't see DOW 14,000.

2008 Dec 10 11:28 AM

[jepittman:]

I think this is a good example of how negative sentiment has gotten in the investing public. Despair is the final emotion experienced in the declining phase of bear markets. IMO this is where new bull markets are born.


On Dec 10 11:28 AM The LFB wrote:

> The consumer is devastated. Their most important assets-home and
> 401k, have been severely compromised at the same time their balance
> sheets were levered the most in history.
>
> Just look today's oil inventory numbers-demand for finished products
> fell 6.1% from last year even with all the price declines.
>
> The next ten years are highly likely to be very rewarding? If your
> grandchildren live to be 100 years old, they won't see DOW 14,000.
>
>

2008 Dec 10 11:57 AM

[tjmmz9843:]

The broad, average P/E ratio hasn't corrected enough for us to enter a new long-term (secular) bull in stocks. It should fall below 10, as it did in 1920 and 1948 and 1982, the approximate starts of previous secular bulls. People should detest stocks and seriously think no one can possibly make money in them, at the start of a secular bull. We're not there yet.

Having said that: we could soon be in a short- to medium-term (cyclical) stock bull.

2008 Dec 10 12:40 PM

[Archman Inv...:]

This entire article is a joke.

Fact: the top 10% of this country owns and controls 90% of this country's net worth. Americans owe just under 1 trillion dollars in credit card debt alone (not including car, mortgage, etc)

The average american family has less than $30K is mutual funds, have been draining money out of their 401(k)'s at an alarming rate, etc.

Home values when all is said and done will probably have fallen almost 60% from the top, with the majority of americans taking out over 85% of their equity since 2003.

The US consumer has been, and is, devastated.

Enough with these pump monkey articles. There are way to many people out there like myself, who know the facts about who really owns this country and who controls the wealth.

The average american family is always only 3 paychecks away from bankruptcy.

2008 Dec 10 12:43 PM

[Hedged In:]

Excellent article -- carefully argued, good data.

2008 Dec 10 01:08 PM

[HiSpeed:]

After the dog ate my comics page, I wasn't sure whether or not I'd get a good laugh today. This article took care of that!

This guy should be on CNBC with the rest of the bad advisers who have screamed "buy buy buy" all the way down. Reality will catch up to you, eventually. It's still working it's way through the market. As deleverage continues, the market will move significantly lower in 2009, probably after this Obama rally has concluded in January.

2008 Dec 10 04:28 PM

[Alphameister:]

Nice article supported by stats instead of the emotional rants characterizing most comments on your post. Having said that, statistics can hide a lot of mischief. If 70% of the cumulative debt is owed by those who own 30% of the cumulative equity, the country would still be in a lot of trouble!

2008 Dec 10 06:21 PM

[Steven Hansen:]

"From 1980 to the present, for U.S. households in the aggregate, all of these obligations as a percentage of disposable income have grown from 13.8% to 17.5%."

not true. go back an revisit the chart as it increased from 24.9% to 31.35%. you need to add columns together.

www.federalreserve.gov.../

the whole argument revolves around "averages". the baby boomer to the graduate, the ceo with the golden parachute to the disabled.

does anyone believe the spending habits of the a large percentage of the baby boomers are altered? how about the property owner whose mortgage is adjusting, or the retiree who lost his savings? How about the creditor who cannot get more credit?

It does not take much of a percentage change to depress an economy.

it is easy for me to see a few percent here and there.

don't fool yourself with averages.

2008 Dec 10 11:01 PM

[notsosmart:]

the march 2009 unemployment figures will tell the tale. at that point if you about double the govt. figure you will be close to the truth,in my opinion.nothing can happen if people dont have jobs.after pulling in the scarce xmas $ & avoiding the gift cards,many businesses will close in jan.2009. hope im wrong.

2008 Dec 11 01:32 PM

[mrresponsible:]

I think you did a good job with this article. It seems to me that this downturn will affect severely about 20% of our U.S. population, mostly the lower skilled and lower educated. But some very wealthy people have been really damaged but their standard of living won't decrease very much.

When everyone is pessimistic - be optimistic - the U.S. has a huge economy and we can absorb a rather large downturn but people are going to have to be creative and willing to learn new skills. As Greenspan defined it as "creative destruction". The problem is that so many people do not really have the capability to learn new skills - something greenspan is not aware of, obviously.

2008 Dec 11 09:38 PM