Are Strategic Defaults Fueling Consumer Spending?

| About: VanEck Vectors (RTH)

The consumer is dead… Long live the consumer!

We’ve faced some very bipolar news on the US consumer over the last two years. With the unprecedented turmoil in the markets, a real estate market that remains depressed and illiquid, unemployment stubbornly high, and shaky financial ground to begin with – most analysts (myself included) completely discounted the consumer’s ability to spend.

Since consumer spending is known to account for roughly 70% of GDP, this has not been good news.

But with all the headwinds, and with all the negative publicity… the consumer, it appears, is beginning to step up to the plate and once again spend us into recovery.

It should be considered good news, I guess. After all, numbers don’t lie and the statistics point to a relatively strong consumer with money in his pockets (or maybe plastic) and a list of wants akin to a seven-year-old at Christmas.

The strength is wide across the retail sector. Apparel stocks like Lululemon Athletica (NASDAQ:LULU) and relatively new IPO Rue 21 Inc. (NASDAQ:RUE) are only slightly off their all-time highs. Restaurants like growth stocks Chipotle Mexican Grill Inc. (NYSE:CMG) and luxury Morton’s Restaurant Group Inc. (OTC:MRT) have staged impressive investment gains. Retailers from budget conscious Family Dollar Stores (NYSE:FDO) to high-roller Tiffany & Co. (NYSE:TIF) are all trading as if the consumer is healthy and spending once again.

And despite my reservations on this sector, I imagine that retail same-store-sales which will be reported on Thursday will show at least a stable pickup in consumer spending.

Where is the Money Coming From?

It’s been quite a mystery to me for some time now. Exactly where is all this pocket change coming from – especially considering the difficulties we are seeing in other areas (savings rates are once again headed lower, consumer credit hasn’t expanded by any material amount, and despite positive payroll headlines, the underlying report is full of holes).

It wasn’t until this past week when a colleague mentioned the term strategic default did I realize what was likely occurring. Many consumers are spending their mortgage payments! It’s beginning to make sense in the most disturbing way. As homeowners face staggering payments on houses that have negative equity, a large number are simply deciding not to pay their mortgage bill, resigned to the fact that eventually they will lose their house.

And what happens with the money that would have been sent to the lenders? Well, an increasing mentality of “eat drink and be merry – for tomorrow we’re evicted” has set in.

It didn’t used to be this way. For decades, the US consumer placed priority on home ownership. We might miss a credit card payment, and we might put off that family vacation, but we were NOT going to default on our mortgage. After all, home ownership was a privilege, and a serious wealth-building opportunity. Heck, even today there are plenty of retired Americans who are living solely on the equity they built in their homes over a number of decades.

But a sense of hopelessness has emerged when it comes to residential real estate. The principal of home ownership as a tool for wealth building is being sharply disputed. As adjustable mortgages reset to higher rates and payments become more difficult to make, we are likely to see even more homeowners throw up their hands in disgust. If home prices are likely to be low for years (if not decades) then why sacrifice to pay the mortgage on a home where the mortgage is much higher than the value?

Many consumers are willing to turn in the keys and walk – hoping maybe to get into a better deal once their credit is repaired.

On top of the negative equity issue, restrictions meant to help consumers are actually reinforcing this idea of strategic default. The past and current administration have both made it a priority to keep homeowners from being foreclosed upon whenever possible. Lenders are required to go through a series of bureaucratic steps before enforcing a foreclosure and many times this process takes several months to over a year to execute.

The good news is that homeowners who are truly struggling will be allowed to re-negotiate rates, possibly receive a write down on their principal owed, and participate in other federal and state programs aimed at giving them assistance.

But the dark side of this process is that many homeowners are purposefully not paying the mortgage in a strategic decision to allow the foreclosure process to happen and in the meantime to enjoy having the extra spending money. It is estimated that for every foreclosure on the market right now, there are five or six homes in strategic default.

How Long Can This Last?

The additional measures aimed at keeping homeowners in their houses and encouraging banks to write down loans may very well continue this process for some time. As with many other “moral hazard” issues, the intentions of regulators may be noble, but allowing a broad portion of the population (whether they be financial institutions or individual consumers) to escape without taking responsibilities for their actions will inevitably cause irresponsible behavior.

It would not surprise me to see several more months (if not a few more quarters) of strong consumer spending in part due to strategic default capital. Also as the market climbs higher and employment statistics are spun to be perceived as positive, more healthy consumers will likely open their purse strings and begin to increase spending.

The momentum may very well continue and that is why the ZachStocks Newsletter portfolio actually holds a long position in Green Mountain Coffee Roasters (NASDAQ:GMCR). It may surprise readers to see a long position in this name because I have been vocal about my expectation for the stock to decline. I still believe that at the end of the year GMCR will be significantly lower, but with the current investor capital flowing toward speculative retail issues, we are taking a short-term trade as the stock breaks to new highs.

Unfortunately, while the situation looks sanguine on the surface, the longer we inflate this speculative bubble, the more disturbing it will be when the situation begins to unravel. I expect regional banks and holders of mortgage debt to be the first firms hurt as strategic defaults cause them to write down the value of loans.

Foreclosing on mortgages and auctioning off these properties is an expensive process and banks are likely to take significant losses at some point this summer or fall. As strategic defaulters are finally evicted from houses and must pony up rent money, the growth in consumer spending will likely kick in. At this point many speculative retail stocks will become excellent short opportunities.

The timing is difficult to nail down. For now, speculation is being rewarded and irresponsible behavior has led to a better lifestyle for many consumers. Retail traders are likely to be rewarded by either taking a short-term positive positions or sitting on the sidelines. Once this bubble bursts we will be active on the short side, but until that happens it makes little sense to step in front of the strong positive momentum in speculative retail stocks.

Retail Holders (NYSEARCA:<a href='' title='VanEck Vectors Retail ETF'>RTH</a>)

Full Disclosure: Author has long positions in the ZachStocks Newsletter portfolio