Our Economically Frugal Present

Although there are any number of reasons why analysts who weren't incompetent or unscrupulous did not foresee the kind of economic nightmare that has unfolded over the past eighteen months, one key factor, in my view, was the almost blind acceptance of an arbitrary line in the sand between recent economy history and that of the distant past.

For years, we heard prognosticators point to the prior decade, the years since the 1987 stock market crash, or the postwar period as the frame of reference against which then current conditions should be measured. Few questioned the logic of ignoring earlier patterns, in the belief that people are more sophisticated nowadays, or they live in a world where advances in knowledge and technology had permanently altered the landscape.

Now, of course, with financial markets and economies unraveling fast, there is a growing interest in exploring what happened during earlier down cycles in an attempt to figure out what might happen next. Yet even with that, it is not hard to discern a lingering sense among many in the media and on Wall Street that much of what has taken place so far is "temporary" and that circumstances will soon return to "normal."

Given that, I expect no small number of them will continue to be caught out by the fallout from what MSN Money's Jon Markman describes as "An Ugly, Unrecognizable Recession."

Most of us haven't seen an economic decline like this one before, and as the slowdown gets slower, few will be unaffected. Are you ready for the 'frugal future'?

Feeling frugal? You're not alone -- not by a long shot -- as butchers, bakers and billionaires alike are feeling the credit crisis this month in a way not experienced since at least 1946 or even 1938.

It's not just a temporary wave of Scrooginess that's to blame for a retail-sales drop of 7.4% in November and much worse expected for December. It's the combination of two tidal waves of demographics and the global business cycle combining to swamp the middle class, the wealthy and corporations as the recession enters its second year.

If the apathy you've felt at the malls or seen among friends and family is alarming, it's mostly because nothing in our experience, or even most of our parents' experience, has prepared us for a prolonged slowdown. It's almost as if you need to hear the whispers of Civil War widows, or at least see some Depression-era movies, to understand the drain of emotion and hope that has sapped the energy of the full range of the American caste system. Except for those who were already very poor coming into this period, and a few sports and entertainment elites, no one is immune.

Boomers busted

This is largely because all of our economic texts and commentary were created from data that followed the 1944 Bretton Woods conference, which established the U.S. dollar as the world's reserve currency. The post-World War II era harbored the profound societal changes that accompanied the birth of 78 million baby boomers between 1946 and 1964. Recessions tended to be relatively short during the postwar years thanks to the insatiable thirst of the boomers to buy stuff.

During the real-estate slowdown of the early 1990s, many boomers were in their 30s and still in accumulation mode as they bought homes, cars and early versions of home theaters that started with VCRs. The bursting of the dot-com bubble hit the average boomers' retirement portfolios while they were in their 40s, the prime earnings years, and they were therefore able to quickly bounce back and resume the move toward bigger homes, cars and vacations from 2003 to 2007.

Things are much different this time. The median boomer came into the current downturn in his or her 50s, edging closer to retirement in a state of precarious financial health. After a 20-year buying spree, nonhousing durable-goods assets nearly tripled to $40,000 per household. Fueled by the twin forces of a declining birth cycle and the increased availability and acceptability of credit, this accumulative phase is coming to an end.

Bankers, the new villains in America now that we're tired of just blaming CEOs, deserve a lot of the blame. The repeal of the Depression-era Glass-Steagall Act in 1999 -- which brought down the wall separating commercial banking and investment banking -- combined with low interest rates and heightened risk appetites to feed a credit binge that caused U.S. debt-to-income ratios to go parabolic. All of this was unsustainable because it was powered by rising asset values, not income growth.

Our new economic reality -- our "frugal future," in the words of Merrill Lynch economist David Rosenberg -- will be marked by reduced discretionary spending, higher savings rates, asset liquidation, debt repayment and reduced accessibility to consumer credit. It will also not be buttressed by rising flanks of new consumers, because the children of the baby boomers are a smaller cohort and immigration policies are unlikely to change drastically.

The bad old days

The dynamics of this economic future have much more in common with our distant economic past. While a typical post-WWII recession has lasted 10 months, the average length of a recession dating to the Civil War has been 18 months. And recessions spawned by credit crises have averaged 20 months.

Since the current recession began a year ago this month, we can therefore expect a slow recovery beginning late next summer at best -- but more likely in early 2010. ISI Group in New York is forecasting U.S. gross domestic product to contract 3% next year, which would be the worst calendar-year span since manufacturing crashed after World War II in 1946.

The mediocrity of the recovery would stem from the decline in household purchasing power: Falling asset values, both households and retirement portfolios, have caused household net worth to drop more than $7 trillion over the past 12 months, compared with a $2.8 trillion loss during the dot-com bust. Yeah, it's nearly 2 1/2 times worse this time. The historical relationship between net worth and disposable income has Rosenberg looking for the savings rate to rise to 4% as households rebuild their balance sheets, which ought to result in a four-alarm calamity for retailers.

Indeed, during the third quarter, nearly $30 billion in consumer debt was repaid. This is the beginning of an epic change in the way society views financial profligacy and prudence. As a result, a recovery in housing, autos and other consumer discretionary categories will be long and painful. And without some stability in the housing market, it will be difficult for the incoming Obama administration to stabilize the financial system while trying to spur enough government spending to offset the newly frugal American consumer.

Anyone hoping for a gigantic stimulus package to bail out the economy will be very disappointed, because when you combine a massive housing downturn (5% of GDP) with a massive business spending downturn (10% of GDP) and add a massive consumer spending slowdown (70% of GDP), you would naturally need an incredible amount of new spending to emerge just to create an offset. If fiscal spending amounts to $600 billion next year, it would only replace the amount of private-sector spending expected to withdraw from the marketplace in 2009, not add anything really new. Merrill Lynch has calculated that just to keep the unemployment rate from topping today’s 6.7%, a 15-year high, a stimulus package of $1 trillion would need to be added on to the $1 trillion deficit the U.S. is already running.

These are among the many reasons that I expect 2009 to be a challenging year again for the stock market. As you know from my column two weeks ago, I see the potential for a low by midyear below the November low, as corporate earnings decline by 10% or more in the face of a global consumption slowdown and price-to-earnings multiples shrink as investors collectively decide to pay less for every unit of earnings.

The Obama transition team has been talking so far about an $800 billion stimulus spread over two years, the largest on record. That would be around $400 billion per year. Yet look at the recent $350 billion that's been poured into just the banking sector in the past two months by Congress and the Treasury. It may be too early to judge, but most banks are in even worse shape now than when their own private stimulus package was launched. Now just a little more stimulus is going to be spread across the entire economy, and that's supposed to totally rejuvenate the nation?

My guess is that consumers will have the same response as banks: They'll hoard most new funds that come their way or pay down debt rather than buy more stuff. Obviously, a lot will leak into the economy, but probably not soon enough to make a huge difference. And meanwhile, consumption growth in the rest of the world, on which our large multinationals depend for earnings growth, will sink.

Bad news, by the numbers

To get more technical, S&P 500 companies as a group earned $45.95 a share in the four quarters ending Sept. 30, down $78.60 from a year earlier, and the average price-earnings multiple was 22. If earnings fall 10%, to $41.35, and the P/E multiple slips to 15, as expected, the index will close next year at 620, or 30% below today's level. That seems like a reasonable forecast, given what we know now.

Now the somewhat scary thing is that even if you are pretty bullish, it's hard to come up with a target for next year that's very exciting:

• Say you figure that earnings will rebound 15% and investors will decide to pay a 20 multiple. That would be $53 in earnings per share, times 20, or 1,060. That level is 19.5% higher than where we are today, which is great, but in terms of time it gets you back only to the start of October.

• Now say you figure earnings can grow 30% and investors will pay a 21x multiple. That gets you to almost 1,260. This would be a 42% advance but gets you back only to mid-September

The good news? Sure, why not. Let's dream a little. If the S&P 500 rises 20% to 40% next year, then the best sectors and market cap groups would rise 40% to 60%-plus. And if a miracle occurs and fiscal spending actually sparks a recovery, I will point you there without fail. Next week, I'll offer some ideas on what actually could go right and how to plan for it with a small part of your portfolio.

Comments

[basehitz:]

Kudos for being one of the few ahead of this mess when most were still cheerleading. So how's come folks like you, Nouriel Roubini and Gary Shilling are not nearly as frequent on Larry Kudlow? You'd think he'd be grateful from you guys trying to steer people right. If I were a cynic, I might think question Mr. Kudlow's motives in guest selection. Regardless, I watch a lot less CNBC (aka bubbleTV) and read a lot more. Thank you.

2008 Dec 28 11:11 AM

[Prudent Man...:]

Arthur Levitt in his "Numbers Game" speech in 1998 admitted that corporate finacial statements were rigged. Unfortunately, as head of the SEC he let Robert Rubin control him and did nothing about it.

How do you analyze an investment if you have no idea what the assets are?

2008 Dec 28 01:39 PM

[acudoc:]

When you allow a privileged elite to control the issuance of money based on debt, of course you must eventually have a correction. This is the mother of all corrections and all the pundits are running around like chickens with their heads cut off----how do we fix this, how do we fix this, how do we fix this? IT CAN'T BE FIXED! Go ahead, re-arrange the deck chairs on the Titanic all you want. The unconstitutional debt-based, fractional-reserve, fiat money system is itself the problem. When even Nobel Prized winning economists cannot see the root of the problem and continue flailing away ineffectually at the branches, you know we are in for some turbulent times that will eventually humble even the most arrogant, and necessitate a return to honest money and ethical, 100% reserve banking administered as a service to society rather than as a scam to screw the productive class.

2008 Dec 28 02:40 PM

[fran:]

remember sir--

to attract the masses to CNBC advertising[that is their business product? right?] an ultra positive message must be conveyed, lest the audience become dour and tune-in elsewhere. too many guests appearences of the author's ilk is bad for large audiences.

Kudlow sells advertising, not necesserilly good investment advice.

remember, it's the ad revenue, stupid!



On Dec 28 11:11 AM basehitz wrote:

> Kudos for being one of the few ahead of this mess when most were
> still cheerleading. So how's come folks like you, Nouriel Roubini
> and Gary Shilling are not nearly as frequent on Larry Kudlow? You'd
> think he'd be grateful from you guys trying to steer people right.
> If I were a cynic, I might think question Mr. Kudlow's motives in
> guest selection. Regardless, I watch a lot less CNBC (aka bubbleTV)
> and read a lot more. Thank you.

2008 Dec 28 04:20 PM

[scotty1560:]

worth repeating from "acudoc"

"When you allow a privileged elite to control the issuance of money based on debt, of course you must eventually have a correction. This is the mother of all corrections and all the pundits are running around like chickens with their heads cut off----how do we fix this, how do we fix this, how do we fix this? IT CAN'T BE FIXED! Go ahead, re-arrange the deck chairs on the Titanic all you want. The unconstitutional debt-based, fractional-reserve, fiat money system is itself the problem. When even Nobel Prized winning economists cannot see the root of the problem and continue flailing away ineffectually at the branches, you know we are in for some turbulent times that will eventually humble even the most arrogant, and necessitate a return to honest money and ethical, 100% reserve banking administered as a service to society rather than as a scam to screw the productive class. "

The economy will need re-structuring. Financing schemes, entitlements,tax
laws, government spending, government created inflation, taxation have
really pushed the limits of society about as far as possible- I'm
afraid is leadership doesn't find a leader willing to address these issues ,
than we are headed for certain destruction in the next 5-15 years. One
can assume we are headed for higher taxation, directly or indirectly, and
much higher costs of living through inflation.

2008 Dec 28 05:57 PM

[WAKEUP:]

Mr. Panzer, you have a much more realistic view of what's coming than the vast majority of writers whose articles I have read. I personally have been very skeptical of the cheerleading that started almost as soon as the downturn started. I share what I comprehend as your view that it's going to be a much subdued American consumer, as the reality sinks in that we simply cannot afford all this stuff we've been buying - along with the realization that we didn't need half of the stuff, anyway. Surprisingly, for me, I find myself not entirely dissatisfied by the prospect of a more sedate, sober, and sane lifestyle spreading across this country, even if it is driven by economic necessity.

2008 Dec 28 08:02 PM

[perceptions...:]

The basics of economics have been and are, being ignored!!!

Supply & Demand have and will, dictate what happens in the economy.

The basic economic assumption of Growth has been slowing and will now go into reverse.

Baby Boomers earning & spending capacity and the Oil production have now Peaked.

You tell me, WHAT IS GOING TO REPLACE THE BOOMER DEMAND & THE OIL SUPPLY that is sustainable, over time ???

2008 Dec 28 08:07 PM

[prudentinve...:]

One overlooked factor is the slow down, or even end, of the "brain drain" towards the US. Since the end of WWII, we had the advantage that many of the world's best scientists and engineers lined up to emigrate to the USA. Although this has not come to a complete stop, it has slowed down significantly in the past fifteen years, as the financialization of our economy moved a greater proportion of its economic rewards to the financial sectors and thus away from the science/engineering sectors. Simultaneously, the improvement in the EU economies created greater opportunities for European and developing countries' scientists and engineers in Europe.

2008 Dec 28 08:11 PM

[tdillian:]

to the author:

great article.. I work as an engineer in silicon valley, and I make a good living.. I have a decent sized house.. I drive a civic hybrid.. and paid off all my student loans just this past year.. but of course I still have other debt.. the mortgage, the car payments.. etc

your statement that the consumers, if given $$ will "hoard it", I can pretty much agree with it.. any money I get will be any extra car payment I make or it will go to my mortgage.. it will certainly not be toward buying anything..

I don't think this attempt to reinflate the bubble is going to work.. I don't know when I might lose my job, some of my friends have already lost their jobs.. so why in the world would I go on a spending spree.. that money will either go into my bank acctn or will pay down debt..

and I am pretty sure I will not be the only one thinking along these lines.

2008 Dec 28 11:45 PM

[Alan D.:]

Frugality it take as an advantage during economic hard life and it also bring us a self reliance that is effectively to the teenage to teach them how to handle them a effective way to become a thrifty person. I recommend you read this article I found on the payday loan blog at PersonalMoneyStore.com... It talks about how frugal financing can help with better budgeting and relieve some of your financial tension. Poor spending habits rob you of more things than you can possibly imagine. Get away from the cycle of late payments, a payday loan, and debt by implementing a financial strategy that is both practical and realistic. Create a budgeting plan that will suit your needs and still allow progressive financial growth of your net worth. This financial strategy will bring you more financial freedom and a rock solid budget to live off of. Read more about frugal financing and payday loans on the payday loan money blog at PersonalMoneyStore.com...

Jan 22 04:48 AM