Pumping Up the US economy

May 11, 2005

Holdings

	May-05
1	F
2	NBG
3	YHOO
4	NKE
5	BA
6	VRSN
7	SNP
8	CAT
9	JNJ
10	NSM
11	CA
12	FNF
13	MWD
14	TKC
15	HMC
16	CRYP
17	X
18	AAPL
19	COP
20	ACH

Performance of Individual Stocks For last 3 months:

May-05
FNF	-23.26%
COP	7.01%
CAT	-1.57%
NKE	-7.78%
BA	12.02%
VRSN	10.28%
SNP	-4.51%
YHOO	2.14%
JNJ	2.02%
NSM	2.00%
CA	3.98%
F	-25.41%
MWD	-16.95%
TKC	-5.29%
HMC	-4.64%
CRYP	40.85%
X	-20.15%
AAPL	-12.29%
NBG	2.67%
ACH	-6.75%

Total Increase (Decrease) since last quarter: -2.28

Additions: None

Subtractions: None

Commentary: My commentary this quarter has a title: The US Economy on Steroids.[1] It is my belief that the factors impacting the stock market and US economy over the past 30-40 years have changed dramatically. These changes are:

The role of debt
Changes in savings rates and consumer spending patterns
The supply and demand dynamics for US equities

I believe that these forces are unsustainable, and have led to artificially high growth rates in the US economy and also artificially high valuations. I think the data speaks for itself, so there is minimal commentary. If you want to discuss any of these or have any questions, please email me at jvbandy@gmail.com

The Role of Debt

Over the past 40 years, debt has come to play a major role in many aspects of America – in households, in corporations, and in governments at the municipal, state, and federal levels. I don’t have the data to examine all of these factors, but I will look at some.

Household debt can be broken down into two components: consumer credit and mortgage lending. The chart that follows shows the evolution of consumer credit since 1943 and the second shows the evolution of single family mortgages since 1990:

Source: Federal Reserve, BEA

	Single-Family Mortgages
1990	$2,614,681
1991	$2,781,692
1992	$2,947,273
1993	$3,106,228
1994	$3,283,212
1995	$3,451,230
1996	$3,674,711
1997	$3,909,870
1998	$4,266,203
1999	$4,691,478
2000	$5,110,252
2001	$5,639,775
2002	$6,373,794
2003	$7,174,197
2004	$8,243,573
2005	$9,380,446
2006Q1	$9,608,314
2006Q2	$9,838,491

Source:	http://www.ofheo.gov/Research.asp

The federal government’s deficit currently stands at around $8.8 trillion (updated June 1 2007). Though this is the highest the debt has ever been in absolute terms, it is much lower as a percentage of GDP than it was during the great spike in growth in WWII.

Source: Wikipedia (http://en.wikipedia.org/wiki/U.S._public_debt)

Source: US treasury (http://www.treasurydirect.gov)

The above graph shows both the growth of the debt in absolute terms and the sensitivity of interest expenses to increases in the average interest rate.

Changes in savings rates and consumer spending patterns

Since 1929, America has seen its savings rate rise and fall, as the following chart shows:

Source: BEA (http://www.bea.gov/bea/dn/nipaweb/SelectTable.asp?Selected=N)

The causes for low or negative savings rates in the 1930s and the 2000s appear to be quite different. The depression of the 1930s probably forced Americans to eat into their savings, while the affluence of recent times, combined with phantom savings in the housing market, has eroded the priority of savings as part of the American ethos. The probable effect of rising housing prices since 1990 is shown below.

Source: BEA (http://www.bea.gov/bea/dn/nipaweb/SelectTable.asp?Selected=N), Office of Federal Housing Enterprise Oversight (http://www.ofheo.gov/media/pdf/1q07hpi.pdf)

The scatter plot and corresponding linear regression shown below show the strength of this correlation with the R^2 value of .716:

Source: Source: BEA (http://www.bea.gov/bea/dn/nipaweb/SelectTable.asp?Selected=N), Office of Federal Housing Enterprise Oversight (http://www.ofheo.gov/media/pdf/1q07hpi.pdf)

As with any strong correlation, it is important to understand whether the dog wags the tail or the tail wags the dog. In this case, I am fairly certain from qualitative evidence that rising housing prices have caused people to save less, as their perceived wealth is bolstered by increased home equity. If we assume housing prices have a sustainable level of increase of about 4 percent per year, then the savings rate from this correlation should be around 5 percent in this country, a little below its 70 year historical average.

A slight rise in personal savings from -1.4 percent to 5 percent may not seem like much of a change, but since personal consumption is such an important part of the USA’s GDP, this effect could be devastating. The following charts show the importance of personal consumption as the major component of the US’s GDP:

The following chart shows the relationship between personal consumption and GDP in the USA in a slightly different way:

There are three key things about the above charts:

For most of the last 75 years, personal consumption has represented roughly 60-70 percent of GDP
Periods where personal consumption went outside of these bounds were periods of extreme economic or geopolitical upheaval
The gradual increase of personal consumption as a share of GDP from 1982 onwards corresponds with the gradual decrease in the personal savings rate in the USA.

Also, it in interesting to ask what would happen to the GDP in the USA if personal savings rates returned to their predicted sustainable rate of about 5 percent, assuming the housing market stabilizes[2]. A roughly 650 basis point increase in personal savings, and the corresponding 650 basis point decrease in personal consumption (this is a zero sum game), would probably have a corresponding effect on GDP levels, accounting for some smoothing out over time. In other words, the US GDP is probably about 6.5 percent too high right now, and will have to shrink (either in absolute terms or by reduced growth rates) to allow for this adjustment in lower personal spending to occur.

The supply and demand dynamics for US equities

The composition of investors in the US equities markets has changed dramatically since 1950.

Source: US Census Bureau (http://www.census.gov/compendia/statab/banking_finance_insurance/stocks_and_bonds_equity_ownership/)

The following series of charts shows this evolution in a slightly different way:

Source: US Census Bureau (http://www.census.gov/compendia/statab/banking_finance_insurance/stocks_and_bonds_equity_ownership/)

The most noticeable long term trend in the above figures is the decline in importance of household investors, and the rise of mutual funds, governments, pension funds, insurance companies, and foreign investors as players in the US equities markets. What is the effect of all of these new players? I am not sure entirely. However, I do think there are supply and demand dynamics here. I think a large reason equity prices are trading at higher multiples to their earnings (and also book values) now than in generations past, is that the number of interested parties is such that demand for US equities has grown at a greater pace than supply.

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