Seeking Alpha
Retail investor, long/short equity, dividend investing, medium-term horizon
Profile| Send Message|
( followers)  

Those who assert that the U.S. consumer is tapped out, too deep in debt to contribute to an economic recovery, would do well to take a look at the DSR (Debt Service Ratio) and FOR (Financial Obligations Ratio), as published by the Federal Reserve. The 2nd quarter 2011 data were released last week.

(Click to enlarge)

The point is, that the U.S. consumer is deleveraging at a very rapid pace, and both of these ratios are beginning to approach record lows, and will hit them within the next few quarters. In the past, these low points have preceded strong stock market performance.

FOR related to S&P 500 Performance

As a way of exploring the relationship, the following scatter chart shows the 5 year forward performance of the S&P 500 as a function of the FOR.

(Click to enlarge)

The 5 year period is arbitrary: I felt it was a useful way of looking at the data for those who take the long term view. Data extends from 1Q 1980 to 2Q 2006, due to the five year look forward implicit in the time frame selected.

The Magic Number

The FOR for 2Q 2011 is 16.09. Applying the formula, -5.73 X 16.09 = -92.19 + 106.62 = 14.42. This interpretation of the data suggests that investing today in the S&P 500, the investor can anticipate earning 14.4% annualized for the next 5 years, to which can be added a dividend of about 2%.

Reservations and Qualifications

R(2) at 0.35 is not that impressive.

Demographics is different. The baby boomers are reaching retirement age, or rapidly closing in on it, and will need to continue deleveraging. Some may elect to go with reverse mortgages, as the home may be the largest financial asset.

The underlying assumption, that good citizens borrow as much as their income permits, in order to live the good life now, may become less acceptable. Rates on 15 year mortgages are very low, and those who can swing the payments may elect to refinance for the shorter terms.

Cars don't rust out and break down as fast as they did 40 years ago.

(Click to enlarge)

New cars are typically financed for five years. A glance at the chart suggests that large numbers of cars are coming off financing, liberating substantial spending power. Before the financial crisis, many drivers never paid their cars off in full, buying a new car before they had finished paying for the old one.

Credit card defaults have been going down steadily. The money that previously went to making car payments can be diverted to reducing other debt. That would be the normal trajectory of deleveraging. Credit cards frequently feature punitive fees, interest and late payment structures. They are often the tipping point for personal finances. That 450 a month that was going to car payments can be turned against the nastiest credit card, staunching the bleeding from usurious rates and repetitious penalties for trivial offenses.

I suspect that a better fit could be obtained by including the level of the S&P 500 as a ratio of GDP or corporate profits, or any other variable reflecting the relative level of the index. As of today, the index is extremely low on a forward P/E basis.

Investment Implications

First, macro viewpoints relying on the assertion that the U.S. consumer is desperately overloaded with debt should be qualified by reference to the data presented here.

Short-term, there are many negatives.

Long-term, U.S. corporations have strong balance sheets, and the consumer is well able to reduce principle on his debt load. U.S. banks have been recapitalized, and now have strong balance sheets. The debt load seems to have transferred itself to the U.S. government, somehow. But 3 out of 4 isn't bad.

Risk/reward for investing in U.S. equities is very favorable.

Source: The Household Debt Service Ratio And The S&P 500