Why The Consumer Will Suffer This Fall And What You Should Short

by: Adam Ballantyne

Low savings rates, a risky and misunderstood expansion of credit, and continually high unemployment make me bearish this season.

First, the unemployment rate remains at 9.1%. This means personal income has remained relatively constant over the past 4-5 months and, as far as we can tell, will stay this way in the near term.

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Now for a somewhat deeper analysis. If we look at personal savings, it's clear that much of the recent spending has likely come from these decreases in the personal savings rate. This is expected in recessions, as it has happened often in the past that consumers laid off or underemployed (working less hours and/or for less money) will try to maintain most spending in the short term; however, unemployment hasn't been above 8% for more than 32 months since the Depression, and this statistic will have serious consequences for those relying on savings to maintain their current spending habits. If we continue to assume income has been constant (which this falling savings rate is confirming), and we continue to assume that the near term will not bring many new jobs to counteract this lack of savings, then we must conclude that there will be cuts in personal expenditures - the falls in savings can only go on for so long.

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Additionally, let's take a look at consumer credit, where things are more interesting. Traditionally, an expansion of credit means that banks are feeling more confident about lending, consumers are feeling more confident about spending and all of the above because of a perceived confidence in the general economy. This can result from a future near term increase in employment, an expected increase in wages, or on a smaller scale from government intervention. This recent expansion is represented in the table below:

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As we can see, during 2009 the recession saw credit fall dramatically from banks, financial institutions, the government, and credit unions. Since last summer, however, there has been a general expansion of credit, likely from the lasting effects of QE2 and the government stimulus. This is not the whole picture, however, and we should take a look at this credit expansion a little further.

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The picture painted here is certainly more concerning. The amount of revolving credit has been declining since the height of our recession (with a slight bump up at the end of 2010), meaning that the lending institutions are still holding back cash to lend and consumers are resorting to other means (such as savings and expenditure cuts) to maintain their lifestyles. Non-revolving credit, however, has accelerated at a fast pace, increasing from $83 billion from Q2 2010 to Q3 2011. Also, 100% of this overall increase in non-revolving credit has come from the government (mostly for student loans), which has almost doubled its non-revolving credit expenses since Q1 2010.

This all means a couple of things that concerns investors. First, banks are still afraid of lending to consumers, and if credit continues to contract, then we'll see additional cuts in consumer expenditures and revenues. Second, the government is still leading the way on credit expansion, so when the government cuts the vast majority of this money due to its long list of debt, we're going to see a general contraction in credit, both revolving and non-revolving.

If consumer expenditure (CE) equals total income (Y) plus available credit for spending (C) plus savings (S), then we have:

CEi=Yi+Ci+Si, (in term i)

... where Y is assumed to be constant in the previous near term and future near term.

Thus, a fall in credit (Ci), expected from a decrease in government spending in the near (and long) term, and a fall in savings (Si), will result in an accelerated decline in consumer expenditure (CEi) for that next term. If we add in the fact that additional falls in expenditure could mean additional layoffs (and thus longer term falls in Yi where Yi>Yi+1), then we have an even grimmer picture, since more unemployment and thus less spending and saving will further exarcerbate the problem.

Investment Conclusion

The S&P 500 may be able to escape some of the consumer goods-based volatility and drops in near term consumer expenditures, despite the fact that we're an economy that relies on consumer spending for ~80% of GDP. Still, I would short overpriced consumer-driven companies, such as Costco (NASDAQ:COST) and Netflix (NASDAQ:NFLX) for non-durable goods and Tiffany and Co. (NYSE:TIF), Fossil (NASDAQ:FOSL) and Abercrombie & Fitch Co. (NYSE:ANF) for durable goods. Here are some of their valuations statistics:

P/E Multiples
COST 24.7X
FOSL 20.0X
NFLX 30.0X
TIF 21.9X
ANF 29.3X

Disclosure: I am short COST, TIF, ANF.