The Detroit Syndrome of Economic Failure

Includes: BP, F, GM, TLT
by: Leif Peterson

An historical reflection of Detroit's failing economy indicates that it was inextricably linked to the US auto industry and weapons complex. What threw Detroit's economy into a tail spin was the unfavorable financial positioning from lack of growth over 20 years in the presence of a very deep recession.

Listed below are several parallels for the fall of Detroit's economy and the potential for the economic collapse of the US economy:

  1. Poor corporate governance among US auto corporations --> unbalanced US government budget
  2. Exorbitant corporate over-leveraging --> US government debt
  3. High wages, benefits, and pensions among auto worker unions --> foreign outsourcing
  4. Foreign penetration of market share --> US trade deficit
  5. Self-delusion of winning while losing (Flint, Saginaw) --> Vietnam, Iraq
  6. Pushing out brands that no one wants --> unwarranted US government-backed sector growth
  7. Deep racial divide in the 60s --> bipartisanship (Republican vs. Democrat)
  8. Dwindling population size ("brain drain") --> loss of foreign interest in US Treasuries ("support drain")

When the above factors interacted with current US economic problems such as political promises and election platforms, monetary policy (printing money), and no currency standard (e.g., gold), there was an ever-increasing risk for economic failure in Detroit. Collectively, what happened in Detroit could appropriately be couched the "Detroit Syndrome of Economic Failure."

Detroit's history is central to US history. Historically, Detroit led the WWII effort to retrofit factories literally overnight to produce aircraft, tanks, jeeps, shell casings, etc. The Chrysler Detroit Tank Plant alone produced more than 22,000 tanks during WWII. The required capacity of iron mines in the Upper Peninsula and Duluth and associated shipping of ore through the Great Lakes to Detroit for such a large-scale high-throughput operation was hugely immense.

Where else in the US could this have happened? Detroit participated in the war effort in other ways. The Stoner 63 light machine gun was designed and produced at Detroit's Cadillac Gage Company.

Although early in the production stage, small quantities of Stoner 63As were hastily shipped to Navy SEALS operating in Vietnam in 1967. Cadillac Gage also produced the gun turret for the M48 tank, amphibious armored personnel carriers, and hydraulic pumps for the space program. In the post-war epoch, Detroit forged full steam ahead with auto production.

The most lively historical remains of Detroit lies in the restoration of vintage automobiles such as the Chevrolet Corvette, 1966-70 Super Sport Chevelles and Camaros, Chrysler-Mopar Barracudas, Road Runners and Challengers, and Ford Mustangs, all of which are in great demand and rather pricey. (Have you priced a 1970 SS-454 LS6 Chevelle lately?). Don't forget the Pontiac GTO, Oldsmobile Cutlass 442, Hurst Olds, and Buick GS muscle cars as well. The tool and die and parts supply industries also flourished during the ramping up of big auto business, and are now toned down due to harsh economic conditions.

What happened in Detroit was partly cultural as well. Detroit experienced one of the worst racial conflicts of all time during the 1967 riot, whose cause was multifaceted (demographics and economic inequality, police brutality, black militancy, lack of social programs for housing and urban renewal). The deep racial divide during the 1960s resulted in a booming surburbia in the 1970s, which eventually carried the torch for the city's economy.

The present prairie-like areas of Detroit's inner city is a warning shot of what can happen to any thriving center of technology or government. In comparison with Houston's population, Detroit's population has decreased precipitously since 1950 as shown in the chart below. The out-migration into the suburbs or away from Detroit is neither reflective of nor conducive to economic growth of the city proper.

Out-migration can also equate to a "brain drain" in which talent slowly disappears. Richard Smalley's (Nobel Laureate) phrase that "money follows brains" would imply that because of population downsizing and a shrinking economy, it would be less likely for future auto-related technology and design centers to open in Detroit.

The recent news that GM is selling the Renaissance Center (its riverfront corporate headquarters) is testament to this. With regard to loss of an important factor necessary for business growth and its parallel for the US economy, there is an ever-increasing loss of foreign interest in long-term US Treasuries. The Treasury is already beginning to witness a price drop in the 20-year notes (NYSEARCA:TLT) because the inflation rate is beginning to exceed the yield, meaning that foreign support of our debt disease is slowly eroding away.

Detroit's economy didn't have to fail. When Houston ran into problems in the oil industry in the 1980s, it quickly transitioned from mostly being a petrochemical industry into partly becoming a technology center through innovation and establishment of Compaq computers (now Hewlett-Packard (NYSE:HPQ)) and a strong IT industry.

Today, Houston's housing industry is quite resilient and has experienced considerably less misfortune than the California and Florida housing industries. A rapid about face in Detroit, however, was hampered by the long-term synchronicity of exposure to a mixture of insurmountable social, cultural, and economic problems. In other words, it was a long slow burn.

Several technical indicators suggest there were warning signs of an impending failure throughout the last 10 years. Looking at the 200-day Jurik indicator for velocity [VEL] and 192-period "early warning" indicator [CFB] for weekly General Motors (NYSE:GM) data below, one can notice that over the last 10 years velocity was negative about 80% of the time. Huge sell-offs are also noticeable when the CFB increased during a decreasing velocity. On the right hand side of the plot, with such a large decrease in price return and negative velocity, one would not expect any large buying or selling in the immediate (distant) future.

Analogously, Ford's (NYSE:F) technicals for negative growth are somewhat similar to GM's (below), confirming the impression held by many that the auto industry was never an investment opportunity for growth and earnings.

On the contrary, a well run corporation like British Petroleum (NYSE:BP), whose annual dividend yield now exceeds 8%, had growth in the positive territory 80% of the time over the last 10 years.

Moreover, the early warning CFB indicator showed significant buying pressure during the post tech bubble bull market of 2003-2007, and died off prior to the end (i.e., early warning) of the bull run in Q2 2008.

Major determinants for the failure of Detroit's economy were the age and size of the auto corporations that the city's economy depended on. Good governance and corporate growth requires an overarching theme of risk aversion and ability to change quickly or "turn on a dime." The older a corporation is, the more it is at risk of failure.

In the field of actuarial statistics, it is well known that there are always competing causes of failure(death), so if one factor does not induce failure something else surely will. Large corporations also can't change quickly. GM simultaneously ran subsidiaries like Oldsmobile, Buick, Pontiac, Chevrolet, Cadillac, Saturn, Saab, Hummer, Detroit-Diesel Allison, and the Electro-Motive Division [EMD].

When is enough enough? In point of fact, EMD, which produced locomotives since 1930, may have been one of the best run subsidiaries to date.

That GM was so large was a major reason for its own demise. In the later stages of large corporate evolution, 80% of management's time is usually spent looking for problems, while 20% is spent on profit generation. This reduces efficiency in productivity, dampens the enthusiasm for verticals, and detracts from augmenting the value proposition -- all of which conflict with the bottom line. One of the major lessons learned after the tech bubble burst in 2000 was not to fill warehouses with product.

However, auto companies still crank out cars like there's no tomorrow. When oil hit $140 a barrel, demand for SUVs and light trucks hit rock bottom only to fan the flames of an already suffering history of negative growth.

Detroit's economy and auto industry may never recover from the economic damage that ensued over the last several decades. In a free-market economy, theory dictates that it is better to let a corporation run its business naturally. This does not include receiving stimulus packages from a government during times of failure. Stimulus money, which is formed out of thin air, is a by-product of monetary policy or printing money, which only causes inflation and increased taxes. The projected US government debt and spending over the next 10 years will be approximately equal to 10-15 times the bailout during the Savings and Loan Crisis, which ultimately cost $125b for the US tax payer.

Another problem that throws "sand in the gearbox" of the US economy is the tendency of the US government to foster and facilitate growth of sectors that have no business growing. The subprime mortgage crisis was caused by a mixture of reduced interest rates, government deregulation of investment banks offering adjustable rate mortgage loans with easy initial terms, and HUD programs (Fannie Mae (FNM) and Freddie Mac (FRE)) to ensure that ~40% of loans be made by families whose income was below the median income of their community.

The next bubble burst will be the collapse of the US dollar and/or collapse of the new weatherization industry.

Economies, in the main, tend to behave through the fundamental property of self-organized criticality. Under the "sand pile" model of this principle, grains of sand are dropped into a pile and over time an ever-increasing pile is produced which periodically has small avalanches. Without the occurrence of local small avalanches, the pile would not grow continuously. If the US economy grew steadily and the major equity markets always increased, the result would be linear growth accompanied by occasional small corrections (avalanches).

However, there is something fundamentally flawed with the markets, since large avalanches occur and there is no linearly increasing trend in price return as a function of time. There is something to be said about putting away retirement funds for 15-20 years and have it go south every time a bubble bursts.

Until these problems are solved, future wealth generations will assuredly require a contrarian approach to asset preservation, such as investing in well-managed companies whose earnings and high-yield dividends increase during bear markets, investing in inflation protected Treasuries, and hedging with (e.g.) precious metals such as gold and silver.

Disclosure: Long BP.