As recently as early May, when stock markets were reaching new peaks, optimism was running very high about the resilience and growth prospects for the U.S. and global economy. Since that time, economic reports have become a mixed bag at best, with successive disappointments in monthly new payrolls, and the reality of a deteriorating housing sector entering the collective consciousness. Markets may now be discounting the disconcerting prospect of a reversal in the cycle of rising asset prices and debt levels, which has been the key driver of the U.S. economic expansion.
Over the five years from 2000 to 2005, U.S. households increased their outstanding debts from $6.96 trillion to $11.49 trillion, an increase of 65% that is far in excess of GDP growth of 25% and real disposable income growth of 13% over this period. This staggering increase in debt has been accommodated and sustained by rising asset values (principally real estate values and to a lesser extent stock prices), which has allowed net worth to climb to record levels. Indeed, there has been a complacent, widespread view about the U.S. economy that unprecedented debt levels do not matter because they are outpaced by “wealth creation” through rising house and stock prices. However, the disproportionate growth in debt and asset values relative to income is a major imbalance and source of fragility in our economy, which has depended primarily on consumer spending and residential building for 90% of GDP growth in this cycle.
As we have seen, asset price inflation is self-financing because it creates the rising collateral for the borrowing that propels prices higher. Yet, this process inevitably reaches the exhaustion point (which we may be seeing now) and is subject to self-reinforcing tendencies in the other direction. The critical risk, of course, lies with the fact that debt levels are fixed, whereas asset values can and do fluctuate. What are now record levels of net worth could erode through a simultaneous deflation of real estate and stock market values, which would clearly have adverse consequences for consumer spending and overall economic activity. We have no way of knowing how severe this adjustment process will be from the credit excesses and real estate inflation we have seen in this cycle. Corrections in real estate pose a more significant threat to the economy than corrections in stock prices, because of the leverage involved in real estate and the risks to the banking sector. It is likely that over the next six to 12 months the Fed will shift from fighting the inflation that has finally appeared in its contrived statistics to fighting deflationary risks in the asset markets.
As a result of steps we have taken over the past nine months to reduce risk and lock in gains, our portfolios are already defensively allocated relative to their benchmarks. Our current allocations to cash and short-term bonds ranges from 22% in our aggressive growth portfolio to 40% in our conservative growth portfolio. Nevertheless, our portfolios have hardly been immune to the recent market carnage and have given back virtually all of their year-to-date gains. Given our desire to protect bull market profits and minimize potential bear market losses, we are likely to take additional steps in the near future to re-position our portfolios. Our strategy is to wait for the first rally from this decline before implementing any changes. Stock markets are very oversold on a short-term basis and we are seeing the types of extremes in investor sentiment that in the past have been associated with market lows.