May 2005

Of Mountains And Molehills

Listening To The Hi-Fi...In the subscriber portion of our site, a while back we penned a discussion regarding the financial stocks as being the current canaries in the proverbial coalmine both for the US credit cycle and for the broader financial markets.  Our thought at the time was that the financial stocks were giving us an early warning sign regarding the broad equity market as a whole. By early April, they had turned down well below their January lows, unlike the leading equity averages at the time, and were putting in both lower highs and lower lows in terms of price patterns. Now that we all know what has transpired since, we again suggest keeping a sharp eye on this sector. At the risk of totally beating a dead horse, the financials are our way of keeping tabs on what the macro market is pricing in at any point in time regarding the dynamics of US credit cycle.  And in our minds, the credit cycle is the key to the big picture. 
        

Of Mountains And Molehills…Although we believe it’s very important to monitor the charts above and the character of the greater US financial sector, we started this discussion with a suggestion regarding the importance of monitoring the financials really as a segue into a larger discussion regarding cash.  If indeed we are potentially at or near the crest of the greatest credit cycle of a generation at least, just how are households positioned for perhaps having to deal with a post-credit cycle economy?  There are boatloads of charts to follow, so get ready.  Post the release of the recent Fed Flow of Funds report, you may have seen it commented upon that households are sitting on a huge pile of cash.  We see it in Street research now and again.  Often referred to as the “mountain of money”.  Money just waiting to go into the market?  Waiting to go into real estate?  Money that is a direct offset to household debt?  Well, we thought it appropriate to take a little closer look and perhaps compare what we see today to historical context.  Are households really sitting on top of a mountain of money, or is it more a molehill?  Well, as you’d imagine, in our eyes, and as with so many financial relationships, it all comes back to the central question of “compared to what?”  And we suggest that the character of household cash will ultimately be very important during the next systemic credit contraction, which of course is ultimately inevitable.  Cash being the major shock absorber in any credit cycle downturn.  We believe this question takes on heightened importance in light of the recently enacted bankruptcy bill as well as the OCC (Office of the Comptroller of the Currency) mandating changes in minimum credit card payment levels.

As you know, the headline savings rate in the US has been bumping along historic lows over the last few years.  We’re about as close to zero as we’ve ever been.  And we’ll be the first to admit that there is plenty of controversy regarding how the reported savings rate is calculated in the first place.  But, one thing that we do cling onto when looking at these savings rate numbers is the fact that the calculation has been consistent across history.  There have been no changes in methodology.  To us, it makes the numbers meaningful when set in historical contrast.  And why is cash, or savings, important?  Academically, the ability of a country to finance its build up of productive capital over time has been through domestic businesses “borrowing” the savings of the country.  And academically, it’s this productive capital that allows any country to manufacture goods that it can “trade” in the global marketplace.  Hence the whole concept of balanced foreign trade.  Now we all know full well that the US has been borrowing the savings of its foreign neighbors, primarily Asia, for many a moon now.  It truly is one of the big “it’s different this time” issues characterizing the current environment.  When we're speaking of household cash, for the most part, we're really speaking of the accumulated savings component of household financial assets over time.  In essence, we're looking at a balance sheet item.  When the savings rate itself is calculated monthly, it's an income statement view of life.  We just wanted to make that clear before pushing ahead.

OK, so just how much cash assets are US households sitting on as of the end of 2004?  A very simplistic definition of cash includes the following:  Checkable deposits and currency, time and savings deposits, money market funds and foreign deposits.  As of 12/31/04 the number stood at just shy of $5.7 trillion.  On face value, that's one big number, right?
       

Before pushing ahead and looking at a number of household financial asset relationships, we're going to be very charitable and broaden the definition of household cash.  For the sake of giving households the total benefit of the doubt when looking at supposed liquidity and accumulated savings, let's also include all bond fixed income holdings as a form of cash in addition to what we showed you above.  This would include household investments in Treasuries, savings bonds, open market paper, muni and corporate bonds, agency securities, mortgage paper and foreign bonds.  We're trying to cover the waterfront here and assume these are relatively liquid assets that could be tapped at a moments notice, so to speak.  Collectively, as of year end 2004, these household bond asset holdings totaled $2.265 trillion.  If we add these assets to the cash assets previously described (checking, savings, MMF's, etc.), we come up with a total of $7.95 trillion in total household cash and near cash assets for the 4Q period end.  As you can see, taken strictly on face value, it's no wonder many a commentator has referred to this "mountain of money" as one big financial backstop.

We'll keep the comments short and let the graphs do the bulk of the "talking".  In the following pictures of life taken as of 4Q period end, remember that we are using the broadened definition of cash, inclusive of all household bond asset holdings.  As we mentioned, the question of cash levels "compared to what" is what we believe to be of utmost importance when pondering an inevitable credit cycle downturn.  Let's start off with household cash relative to household common stock holdings.  As you can see below, cash as a percentage of common stocks stands at 71%.  The near sixty year average is 153%.  It is clear where this relationship stood during historic major equity market lows of the late 1940's (prior to the bull of the 50's), the mid-70's and the early 1980's.  We're currently miles away.  The all time low for the period shown was seen in late 1999 at 53%.  Clearly we're much nearer historic lows than not.  We sit at a level near what was seen at the peak of the 1960's equity bull.  And this is all despite some pretty significant equity price erosion in aggregate since the first quarter of 2000.
       

In terms of household cash relative to real estate holdings (at market value), the following chart speaks for itself.  We currently rest at an all time low.  It should be of little surprise at this point in the residential real estate cycle.
       

Very quickly, let's put a little summation sign around what you see above.  As you know, the two most significant household assets are real estate and common stock holdings.  So what about the history of cash as a percentage of total household assets?  Look no further than the graph below.
      

It's perfectly clear that from the mid-1940's to the early 1950's, the ratio fell pretty hard.  We'd guess that memories of the depression were still burning bright in the minds of many a household ten short years later in the mid-40's.  But what also stands out like a sore thumb in the above chart is the relatively constant nature of this ratio between 1950 and 1991.  Cash as a percentage of total assets hovered between 18% and 21% for forty years.  Through significant stock market ups and downs and through a baby boom generation significantly helping to push up the price of residential real estate in the 70's and 80's.  Along come the 1990's and cash as a portion of total household assets begins to drop like a rock.  As we have said many times in discussing many different data points, we believe we have lived through a period of intergenerational change regarding attitudes toward personal leverage.  It's pretty darn clear to us in the chart.  For now, household cash as a percentage of total assets is within a whisper of the lows of the last 60 years at least.  As you know, it's easy to understand why.  With the Fed's reflation campaign in full swing over the last two to three years, cash has been the lowest return asset.  One last comment.  If what you see above is not a very long cycle view of life, then we just don't know what is.  In much the same way that a Kondratieff cycle is a 60+ year affair, are we witnessing something similar above in terms of household attitudes toward cash (inclusive of fixed income holdings)?  Only time will tell.  (And we're not bringing up Kondratieff cycles to suggest that "the end is near" so to speak, but rather to point out that some cycles are much longer term than not.  In a world of relatively continuous inflation over the last six decades at least, cash holdings at the household level just may be in such a cycle.)  As the dollar has lost real purchasing power over time, so have households responded appropriately and lost their taste for cash as an asset class.  Notably, the most recent plunge in this ratio started very shortly after the Greenspan reign began.

Let's quickly turn the tables and look at cash relative to the liability side of household balance sheets.  Remember, our definition of household cash is cash and bond holdings.  As you can see,  we're at a half century low at least in the relationship displayed below that is cash as a percentage of household liabilities.  Never before have US households been so levered compared to their cash and bond holdings.  We currently rest at a level just a little bit more than one half of the last half century average.
       

Although the above ratio is fine for comparative purposes.  The following chart is the data used above translated into dollars and cents.  Total household cash (cash and bonds) less the dollar amount of existing household liabilities.
       

As is absolutely clear, from at least the mid-1940's until 1997, households had always carried cash balances greater than their total liabilities.  But since 1997, the level of household liabilities outstanding has shot to the moon in terms of rate of change.  Why do we say this?  Because since 1997, household cash has actually grown by $2.1 trillion.  It's just that total household debt has grown by $5 trillion.  We suggest that the chart above speaks volumes about how households have compensated for a declining stock market and a very weak US job recovery during the current economic cycle.  The coping mechanism, so to speak, has been household balance sheet deterioration.  As you already know, the monetization of inflating residential real estate assets has played a huge role in this phenomenon.  Humble question.  For how much longer can what you see above continue?  Just how much deeper does the hole between household cash and liabilities get before households perhaps have a financial epiphany of sorts?  

The reason we suggest this question is worth some thought is that as we look ahead to a baby boom generation who is pushing toward retirement age, cash sure has the potential to be one of the many household assets quite in demand to fund, or help fund, the reality of retirement living expenses.  Just where is this living expense cash going to come from now that cash as a percentage of both household assets and liabilities is much nearer its modern historical lows than not?  We're not bringing up this question to be negative by any means, but rather to seriously ponder the future need of household asset monetization in some form other than increased household leverage (that's already been done in a big way).  Which asset or assets are going to be monetized at some point to fund baby boomer retirement living expenses (that certainly are not about to go down in terms of absolute dollar price trajectory)?  Or will this ultimate need to "acquire" cash simply take the form of reduced consumption and increased saving sooner rather than later?  Again, without sounding melodramatic, this is a bridge that is going to have to be crossed.  There's not much question about it.  With this in mind, we might ask the question, at least for the baby boom crowd, just when does the bull market in cash begin?

A few last charts and we'll call it quits.  First, we want to take a quick look at the rhythm of directional change in household net worth and household debt growth over the last half century.  As you know, as of the end of 4Q, household net worth stands at an all time high in absolute dollar terms.  Coincidentally, so does total household debt.  But what we suggest is important is the nature of change in these household financial characteristics.  As you see in the extended chart below, there is an approximate similarity between household debt and net worth expressed as a percentage of GDP over time.  In our minds, the acceleration in household debt relative to GDP has been a primary catalyst for the inflation of household asset values, primarily equity and residential real estate.  Although this is just our personal opinion, we believe a good portion of the directional change you see below can be attributed to demographics.  As you know, folks like Harry Dent have popularized the notion that demographics drive economic and financial trends.  When we look at the charts below, we can see that in the early 1970's household net worth as a percentage of GDP began a multi-decade secular rise that at least for now culminated with the peaking of the equity market.  Right alongside this rise was the coincident secular rise in household debt as a percentage of GDP.  Do these charts "fit" a number of themes?  Changing household attitudes towards personal leverage.  The fact that the public always chases the inflating asset, first equities and now real estate.  The real demographic force of the baby boom generation.  We believe these graphs do depict these trends.  But again, as we look ahead, we know that the baby boom generation is going to need cash for living expenses if they expect to retire, or are forced to retire for age/health reasons.  A very simple question might be, what happens to household asset values (implicitly net worth) if households slow their acceleration of leverage?  Will the baby boomers simply continue borrowing until planted six feet under?  The demographic rationales of folks like Dent that theoretically explain real world economic phenomenon are implicitly crying out this question.
      

Finally, one last "for fun" chart.  The following is household cash as a percentage of GDP.  And what caught our eye here more than anything else was simply the rhythm of the relationship.  It sure seems obvious that relative to the benchmark of GDP, households have repeatedly gone through cyclical periods of cash accumulation and dissipation over time.  Incredibly enough, the bottoming area in this cyclical relationship has been quite coincidental.  What this chart would suggest is that household cash as a percentage of GDP is approaching, if not at, another bottoming area.  We'll see what happens ahead, but all the charts above tell us that household cash relative to asset values, liabilities, etc, is quite low from an historical point of view.  
       

Interestingly, there have been two major periods of corporate capital spending over the last four decades.  In the 1970's corporate capital spending as a percentage of GDP shot up like a rocket in response to the US energy crisis.  Spending on energy infrastructure was not only profitable, but vital.  (By the way, will it be so again at some point in the relatively near future?  We think so.)  The second great capital spending boom we have lived through in the last half century was the tech spending boom of the 1990's.  Now, in looking at the chart above, we can see that cash as a percentage of GDP was building quite heavily prior to these US corporate capital spending booms.  And during the spending booms themselves, cash as a percentage of GDP fell as basically it was borrowed by the corporate sector and spent.  Where's the juice for the next US capital spending boom?  (There will be another boom, won't there?)

So when you hear it said by some Street commentator that households are sitting on a mountain of cash at the current time, you know that the appropriate response is "compared to what?".  Again, we're not suggesting that the world is about to go dark, but rather we're trying to paint the picture of household financial character and potential financial flexibility as we move ahead.  Looking down the road, some type of credit cycle reconciliation will definitely rear its ugly head.  The financial stocks may be telling us that period is sooner rather than later.  In our minds, the ease of availability, ease of terms and price of credit has been the household substitute for cash in recent years.  After all, one can "always" refi.  One can "always" get a line of credit.  One can "always" get another credit card.  Until the credit cycle reverses, of course.  We believe that for many folks, the distinctive lines between cash and credit have blurred.  But as with household holdings of cash and bond assets, the price, terms and availability of credit is cyclical over time.  In the current cycle, most folks have probably long forgotten that truism.  In a simple world, we'd suggest that it will ultimately take cash at the household level to further purchase equities, residential real estate, etc. as we move forward.  And current cash levels relative to these asset class values look much more like molehills than mountains at the moment.  But we're not in a simple world.  We're in an unprecedented credit cycle.  We're in a finance based economy.  Whether it's the trade deficit or household mortgages, activity is based on borrowing, not cash.  Maybe it will only be with an ultimate change in the credit cycle that the supposed mountain of household cash will truly be seen for what it is, not much more than a speed bump set within the context of history.  Happy motoring modern day credit aficionados.  And watch out for those potholes, OK?