Credit Policies Still Threaten Recovery

In yesterday’s essay we discussed the disconnect between stocks and the U.S. economy. Today, we’re detailing just how bad off the U.S. economy is and why none of the government’s efforts have fixed anything of note.

In 1966, $1 of new debt created $0.90 of GDP growth. As credit usage (consumer, mortgage, and the like) accelerated in the ‘70s, ‘80s, and ‘90s, we “pulled forward” future growth into the present. Put another way, by spending money we didn’t really have, we created the illusion of real massive demand, which pushed prices and the U.S. economy higher rapidly.

This is the power of credit; it allows you to put your current economic “growth” on steroids. A guy with a $50,000 limit on his AMEX can buy a much more expensive car than a guy who has to rely purely on savings (the actual money he has in the bank right now).

This is why prices exploded higher in the last 40 years. Most commentators claim it was inflation. That’s a crock. Yes, the dollar has lost 80% of its value since 1971. But in 1971 college tuition cost $2,400 for an undergraduate degree, the median home value was $23,000, and a new car cost $1,600 or so. Today college tuition is around $100K+, U.S. homes cost $180K, and a new car (decent) costs $15K+.

Put another way, the cost of “things” has soared exponentially higher than the dollar has fallen. This is due to excessive credit. When everyone is buying things they can’t really afford, demand soars, which pushes prices higher. Indeed, one could easily argue that the period 1971-2007 was the largest period of inflation in history (remember inflation is credit and money growth, not merely currency devaluation).

This process of issuing more debt (credit) to achieve growth came to a screeching halt in the late ‘90s/ early ‘00s when the Tech Crash occurred (it was largely fueled by easy money courtesy of Alan Greenspan). However, old (dumb) habits die-hard and the Feds went all out trying to get the U.S. debt machine back on track. Greenspan cut interest rates effectively to 0% and we had a “jobless recovery” fueled largely by one of the largest speculative frenzies in history (large both in terms of caliber and in terms of the asset class investors were speculating on: Housing).

Buying and selling stocks does not require a lot of money. Buying and selling houses does. The period of 2000-2007 represented the pinnacle in the government’s funny money policies, when people were able to buy the largest single asset available to man (a home) for $0 money down.

This all came to a screeching halt in 2007 when we hit a point of debt saturation: meaning that the level of debt creation was now unsustainable because most money was already going towards debt repayments. By that point it took $5 of new debt to create $1 of new GDP growth. The U.S. private sector was more in debt than at any other point in history ($52 trillion). Consumer debt was $2.5+ trillion: an amount equal to 20% of GDP at the time.

This is why pumping the system with more debt will not work. It will only create another bubble (likely in gold as people lose faith in the dollar). Even a 10 year old knows that you cannot solve a debt problem by issuing more debt. However, because our government and the Fed are dominated by academics who have:

1. Never run a real business and so have no clue about actual real world economics
2. Have never dealt with real confrontations other than cowardly students who need to get a good grade and so cannot actually call “BS”
3. Did not see the crisis coming

The government is, essentially, prescribing the same medicine that got our economy sick in the first place. And it will not work. Review the last few pages of this issue and ask yourself “why, if they’re spending trillions, have things not improved for housing, jobs, etc?” You now know the answer. Things cannot improve via the issuing of more debt.

Consumers know this and are doing the only sensible thing: cutting back on spending and saving more money (although most of the alleged “savings” numbers are really just debt payments). Year over Year (YoY) changes in consumer credit are at record drops for the post-WWII era. July consumer credit fell $21 billion, a new record after the record $15 billion drop in June.

We’ve been doing this for some time. Credit card debt switched to negative as far back as end of 2007. The absolute peak for consumer credit came in July 2008 (not the beginning of 2009 as most commentators claim). Since that time, U.S. households have paid off some $110 billion in debt…

And we’ve still got $2.45 trillion to go.

Remember, the U.S. consumer accounts for 70% of our GDP and 16% of world GDP. A major consumer credit contraction like this has enormous economic implications. I don’t know why the following is so difficult for the powers that be to understand:

Mass unemployment + increased savings/ credit contraction = No recovery

Again, consumers are doing the only sensible thing (paying off debt) while our government continues to spend like a drunken sailor propping up businesses who should have failed (banks and autos). This will end very, very badly. And it will crush stocks within the next 1-3 months.

Comments

[Graham and ...:]

There are really two types of inflation; monetary inflation, and credit inflation. Reckless as the Fed has been with the money supply, U.S. prices have soared even faster than this implies, because of the "bidding war" stoked by credit.

Sep 17 03:56 PM

[Econpro:]

It certainly will end badly...its too bad that people are not listening, or they just don' t want to believe it will happen....but it will.

Sep 17 04:09 PM

[Roger Knights:]

Here's a link to a straw in the downdraft: Felix Salmon's short article on Wells Fargo's bad construction loans (via Golden West). Click on the link at the start to Teri Buhl's 3-page article that states, "To give Wells Fargo credit, it may not even know the size of the problem." It also claims that WFC's derivatives exposure is being concealed by extend-and-pretend tactics.

As for stocks getting crushed, all it will take is for Meredith to issue a bearish call.

Sep 17 04:13 PM

[Roger Knights:]

PS: Here's the link to Felix's article:

seekingalpha.com/artic...

Sep 17 04:13 PM

[Wayne A. Co...:]

It is ludicrous to pick up the paper and read stories about what type of recovery we are in when this economy is headed for a major train wreck. Bernanke said this week that the recession is over. This is from the same man that didn't see the meltdown coming in 2007. Comforting.

Sep 17 06:33 PM

[JACV:]

Yes, I believe it will not end well. But as long as banks get money for free and FED keeps monetizing debt stock markets will not crash. When stimulus money runs out and QE stops, then reality will prevail. Until then I am afraid stocks will keep going non sensicaly higher.

Sep 17 07:08 PM

[Fr0gger:]

To be successful in predicting a 'collapse' all the author needs to do is repeat the same tune for days, weeks, months and years.. Eventually he will be right on.
Until then, invest with what the Market does (going up), and not what it's supposed to do (collapse?). Investing per the latter expectation will only result in losing money (as happened to the portfolio the author recommended for a few months now).
People love catastrophes and dooms-day movies, but in reality, there is hope, growth, progress, and ingenuity. All of those will propel all of us forward, and recovery is imminent from any setback.

Sep 17 10:04 PM

[steve graves:]

Absolutely brilliant in its simplicity. Easily the best and most concise piece I have yet read on Seeking Alpha. Hats off, Graham.

Sep 18 07:23 AM

[babum:]

Difficult to believe that academics fail to see the trivially obvious (don't give a loan to someone who is already struggling to repay their debt). Maybe they do, but then they have complicated theories which will be about as successful when applied as "collateralised debt obligations", for instance.

Sep 18 08:43 AM

[CAPITALIZER:]

Graham, you stated a few articles back that your subscribers were poised to profit when the big correction occurred. Hope you didn't encourage short selling back then because your prediction has been dead wrong. What these bears fail to understand is the kind of financial engineering the investment banks are involved in here. Can't you people see this is a collusion to restore market confidence and stability? How would it be if 20 months post crisis the banks started dumping shares, shorting the market and driving everything down? There is already low volume and many are skeptical enough. How would this encourage more players to enter? If everyone was expecting a Sept. sell-off you should have known better than to keep touting that roll-over, imminent crash preaching.
Let me break it down for you; The market will continue to be artificially inflated a little at a time to restore the perception of stability. There will be signifigant dips in OCT. When the selling can no longer be quelled. This will be due to 3 factors. The first is current overbought market levels. The second will be shoddy Q3 earnings in comparison to those high levels. The third will be the wrecked buying power of companies and consumers that caused the crappy earnings. Following these sell-offs there will be buyers to absorb the shares giving the perception they are good to buy at these lower prices.Too much shorting and selling will make some of the players cry and that won't bring in more money. More retail and fund guys will come in as confidence rises. Volume will increase and then the banks will have a lot more players to have fun with. The game will be on again. I won't even charge you a subscription fee for this.

Sep 18 08:09 PM

[sgt.red.blu...:]

I will be checking back on or around Dec 17 2009 to check on your forecast. I am 77 percent in equities, 17 percent in cash. I will not be selling.

Sep 18 08:47 PM

[CAPITALIZER:]

O.K. sgt. wait until OCT. Notice how Oracle's revenues and profits were lower than last year. Look at the market reaction. There was a good 5% dip but the sellers never gained the kind of traction they did last year on dissapointing news. Once the market was satisfied with the lower share price up it goes two sessions later,ready for another run toward that day of real recovery. Unless there is a terrorist attack or some catastrophic event this is the kind of market dynamic we are going to see. Company after company will report lower revenue and profits. Stocks will retrace and then the future recovery will pull the share prices upward. There will be a tug-of-war this fall and winter; the bleak reality of current earnings pulling at equities and then the stronger force of the imminent recovery steadily towing the share prices higher. Last year if you bought on the dips it rolled lower the next day and the next and so on. That market is gone. This fall and winter those that don't want to sell won't see increasing pressure to do so. Those that want to buy on the retrace won't get burned this time. The good volatility will return. As time goes by the market will create a kind of self fullfilling prophecy. For example:If it's way overvalued at $23 reality pulls it back to $21.50. but the market is 6 months forward looking and we get another run at it and up she goes until earnings prove otherwise. By then the good data will become more abundant and off we go again. I wouldn't call this fear vs. greed but more reality vs. hope.

Sep 18 11:58 PM

[CAPITALIZER:]

Why Dec. 17 though?

Sep 19 12:01 AM

[Fr0gger:]

And, you were right on with your hunch regarding going short at the wrong time. The author's shorting recommendations embarrassingly LOST between 9% and 46%. They are not even reported by him for portfolio performance tracking.


On Sep 18 08:09 PM CAPITALIZER wrote:

> Graham, you stated a few articles back that your subscribers were
> poised to profit when the big correction occurred. Hope you didn't
> encourage short selling back then because your prediction has been
> dead wrong. What these bears fail to understand is the kind of financial
> engineering the investment banks are involved in here. Can't you
> people see this is a collusion to restore market confidence and stability?
> How would it be if 20 months post crisis the banks started dumping
> shares, shorting the market and driving everything down? There is
> already low volume and many are skeptical enough. How would this
> encourage more players to enter? If everyone was expecting a Sept.
> sell-off you should have known better than to keep touting that roll-over,
> imminent crash preaching.
> Let me break it down for you; The market will continue to be artificially
> inflated a little at a time to restore the perception of stability.
> There will be signifigant dips in OCT. When the selling can no longer
> be quelled. This will be due to 3 factors. The first is current overbought
> market levels. The second will be shoddy Q3 earnings in comparison
> to those high levels. The third will be the wrecked buying power
> of companies and consumers that caused the crappy earnings. Following
> these sell-offs there will be buyers to absorb the shares giving
> the perception they are good to buy at these lower prices.Too much
> shorting and selling will make some of the players cry and that won't
> bring in more money. More retail and fund guys will come in as confidence
> rises. Volume will increase and then the banks will have a lot more
> players to have fun with. The game will be on again. I won't even
> charge you a subscription fee for this.
>

Sep 20 07:36 PM

[CAPITALIZER:]

All I'm saying is for years these banks and investment firms did not do what is beneficial to the U.S. but only for their benefit and for the company officers. From bonus scandals to taxpayer bailouts, ponzi schemes and outright larceny, this is not the time for these banks to be causing havoc in our financial markets. They are already under a wary gaze and we should have known they would prop things up to make good for all the 401s and pension funds, at least for a while.

Sep 21 05:50 PM

[sgt.red.blu...:]

CAP, Dec. 17 was about three months out from the date of the Graham Summers article.


On Sep 19 12:01 AM CAPITALIZER wrote:

> Why Dec. 17 though?

Oct 09 08:06 PM