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February 2007
We're Swimming In Liquidity, Aren't We?
We’re Swimming In Liquidity, Aren’t We?…Although we’re pretty darn guilty of this ourselves, we can’t turn around these days without hearing the words, “it’s a liquidity driven market”. Trust us, this is not about to go off into yet another discussion of the macro credit cycle. We know global central bankers are “sponsoring” excess liquidity. As we’ve documented recently, we know Wall Street is capable of the same and is fully in gear at this point. We know the derivatives markets underpin excessive risk taking on the part of investors. We know private equity is the new fountain of youth for the institutional investment community. And we know levered hedge funds are not about to change their collective ways any time soon. But
what we don’t know is how households/consumers will react ahead
as, very much unlike the financial markets, they are not swimming
in liquidity. Not by a long shot. At least not relative to the context of history.
It’s probably been a year and a half or more since
we’ve touched on this subject.
Given our fixation on the residential real estate cycle
being an asset class capable of behavior modification when it
comes to the US consumer, we need to fully recognize that US household excess liquidity
availability has largely been driven by the monetization of asset
inflation in both equities late last decade and residential real
estate in the current, to say nothing of additional leverage
assumption. In
literally point blank terms, the following chart documents just
how important stock and real estate asset inflation has been to
growth in household net worth by the decade over the last half
century-plus. As is clear, real estate and equities have
never been more meaningful to aggregate household net worth
expansion than is the case in the current decade. Hence,
incredibly meaningful to consumer behavior.
If indeed we will be seeing a slowing in the growth of household asset inflation ahead, as sure appears to be the case at this point, just where will consumers find their next source of liquidity? Although we sure wish we had an answer to that question, maybe more important is to at least be aware of current circumstances regarding household liquid assets. For if continued household asset inflation is at any point a non-starter anywhere ahead, household liquidity will either be what's on the books of household balance sheets right now, or ever more leverage assumption. It's either one of the two. As you know, God forbid there is any deflation in either household residential real estate holdings or equity values. We'll make this relatively quick. The pictures tell the story in a big way. Moreover, this is in part a review of data we showed you over a year and one half ago. Trends have just gotten a good bit more extreme. Before getting started, a very brief comment on data calculations. In the following charts we are looking at household liquidity or cash, as we term it. They are synonymous in terms of calculation. For this number we are adding together all household bank deposits, CD's, money funds, checking accounts, savings, and other bank-like products together with all household bond holdings inclusive of Treasuries, corporates, muni's, agencies, etc. Long time readers know we try to apply the most broad measure of liquidity to the household picture when examining these trends. Implicitly we are assuming bond investments could be converted to cash with ease. Not included is real estate, stock holdings and private business equity ownership, but that's about it. In other words, we are trying to give households the most broad benefit of the doubt when reviewing their liquidity circumstances. Here we go. The
following is household liquidity as a percentage of household
liabilities. As of 3Q 2006, we're at a level never seen
before in the last half century at least. The declining
trend simply continues unabated, all starting as the baby boom
generation came of age in the late 1970's.
Certainly
what you see above is a ratio. Pretty simple stuff. A
bit more dramatic is what lies below. It's the same concept
as above just expressed in nominal dollar terms. This time
we're looking back six decades. As we detail in the chart,
never prior to 1997 was household liquidity less than total
household liabilities. But as you know, also since that time
the household savings rate has plunged and household liabilities
have mushroomed.
As we've mentioned many a time, what we are seeing in these charts is an intergenerational change in attitudes toward leverage. It's a change in comfort with leverage. But we will be the first to admit, in nominal dollar terms, the magnitude of the change you see above is more than a bit striking. Much more, as a matter of fact. In
the next set of charts we are looking at household liquidity
circumstances expressed as a percentage of household real estate
values and household ownership of equities. It's simply
perspective on the relationship between cash and alternative asset
class ownership at the household level. In terms of
liquidity set against real estate values, it should be no surprise
at all that we are bumping along historical lows right here.
Certainly half the story is contracting household liquidity in
recent years, but the larger issue is the explosion in real estate
values driving this ratio in recent periods. Not THAT big a
deal, correct?
Well it
probably would not be THAT big a deal except for the fact that the
following chart appears as it does. An update of one we've
shown you on numerous occasions. Owners equity as a
percentage of the market value of residential real estate directly
from the Fed Flow of Fund data. Thank you Fed. Very
simple question that really reflects on household net worth and
prompts a few questions about household leverage. In one of
the greatest residential real estate price acceleration periods of
a life time, how come there has been absolutely no increase in
relative owners equity as a percentage of market values since the
real estate mania's inception early this decade, let alone since
the baby boomers came of age in the early 1980's? With the
type of price increases we have seen just this decade, we would
have expected this to perhaps have turned up a bit vertical.
As you know, there's only one explanation. Household
residential real estate leverage in aggregate accelerated at a
greater rate than did prices during the current cycle. And
here we thought nothing could have moved faster than real estate
prices in recent years. Wrong. This shows us just how
meaningful "liquidity extraction" has been in the land
of residential real estate for households this decade.
Again, what's next in terms of a meaningful household asset that
can be inflated and borrowed against? At least for real estate,
it's now a "been there, done that" asset class, isn't
it?
Following
along with the concept, below is household liquidity as a
percentage of common stock ownership. As you know, at least
the last time we checked, stocks are most usually purchased with
cash. Sure, there's plenty of levered equity purchases among
the so-called investment pros, but for mom and pop US households,
very few are margined in any big way. Again, it's simply
perspective. For now, cash levels are off of their most
recent lows (which was really skewed by the stock bubble of the
late 1990's/early 2000's). But interesting is the fact that
this ratio is quite near what was seen in the mid-1960's.
For history buffs, you know that the Dow in 1982 was almost
exactly where it stood in the mid-1960's. As is also clear,
powerful bull markets as began in the early 1980's saw household cash levels
relative to stock values more than three times higher than is the
case today. Again, just perspective on alternative asset
classes and their relative magnitude at the household level over
time.
This is where
we draw this little look at household liquidity to a dramatic
close. Final simple look at household liquidity relative to
total household assets. After seeing the above charts, what
lies below is no surprise at all. It's simply an
amalgamation of much of what was covered above. Up from the lows, but just
barely. The real change began in the early 1990's, just
about the time the credit cycle in the US was set to move into
full swing.
Boom, Boom, Out Go The Lights?...So why is all of this discussion about household liquidity important? What does it mean to our investing activities ahead and the broad economy in general? Although this is somewhat of a generic comment, we believe the significance of these trends find their meaning in demographics. In very simple terms, we know that the baby boom generation is moving full speed ahead into retirement years. Point blank, assuming the boomers in aggregate actually do retire, their need for real liquidity will be meaningful. Very meaningful. Remember, we're referring to a baby boom generation who has "learned" to become relatively dependent on asset inflation for a good many years now to generate household "liquidity". Asset inflation that has truly acted to underpin consumption. Unless we can bank on asset inflation continuing, implying that asset inflation will "fund" boomer retirements as it has clearly funded their lifestyles for at least a good decade now, just where will retirement funds/liquidity come from? This is the issue, and it's clearly of longer term importance as opposed to being something influencing the open of trading tomorrow morning. Can the Fed fund boomer retirements by simply printing money and inciting ever greater household asset inflation? Can the boomers "borrow" their retirement lifestyles as they have done up to this point by taking on ever greater household leverage? As of the 3Q Flow of Funds report, 47% of total household assets were comprised of real estate and equities. Another 16% were comprised of what is termed tangible assets and consumer durables. What are these? Cars, boats, furniture, appliances, art work, jewelry, etc. Not exactly the stuff the local grocer will take in trade for food or the local utility will accept for heat and electric service. Another 15% was the "cash" we described above (all bank vehicles and all bond holdings). The remaining big household asset item was pension fund reserves. As you know, as time passes, fewer and fewer households will be covered by traditional pension plans. Given that we are looking at over 75% of household assets in real estate, tangibles and bond/cash assets, again, where does future liquidity come from for the boomers ahead? Of course the most obvious answer is the sale of financial assets. Not necessarily proactively, but by sheer default. It's no wonder demographers such as Harry Dent are painting an outright nightmare economic/financial market outcome starting literally in five years. (For any familiar with Dent's work, you already know he has very quietly mentioned the word depression a time or two in his outlook). Incredibly
enough, against this backdrop of what has been a relatively
dramatic drop in household liquidity in its most broad definition
over the last few decades, current and forward financial
obligations demanding here and now liquidity service have only
gone ever skyward. As of 3Q 2006, the household debt service
ratio rests quite near all time highs, up quite meaningfully over
the past quarter century as the boomers have borrowed against
inflating personal assets.
Perhaps
nowhere is this more dramatic than in what you see below.
All time highs as of last year's 3Q period end. Remember,
the boomers in aggregate are in their peak earning years right
now. Depending on the character of the US economy ahead,
will boomer earnings and personal income accelerate meaningfully
enough to knock down this ratio? Or will the boomers
essentially be forced to liquidate a very meaningful portion of
their probably most liquid holding - financial assets - to
continue to fund the obligations implicit in the chart below as
their peak earning years pass? Because what won't pass is
the long term debt service on mortgage obligations that are
already on the books of US households.
As you know, the boomers have been funding and accumulating financial assets in their IRA's, 401(k)'s, profit sharing plans, hopefully personal accounts, etc. for decades now. In looking at the historical character of declining household liquidity and coincidental growth in household financial obligations largely due to the explosion in mortgage debt over the past few decades, a concern has to be that somewhere "out there" the boomers will ultimately initiate a period of net distributions in these very same IRA's, 401(k)'s, etc. It's a given that since defined benefit plans are virtually extinct in terms of new plans or employee additions, existing plans will become self liquidating in the decades ahead. Financial assets inside these plans will be under constant and consistent distribution at some point in the not too distant future. Will we basically be looking at this decades long boomer financial asset accumulation experience in reverse, exacerbated by the fact that households have such a surfeit of liquidity at present? Again, it seems no wonder Harry Dent is more than a bit worried. Although
this is clearly a longer term statement than not, we believe we
need to factor this set of circumstances into our investment
decision making. Point blank, at some point ahead, the hunt
for retirement liquidity will be on in a big way for the boomers. And
this suggests to us that yield will be an enduring and meaningful investment theme
if indeed demographics can and do influence real world economic
and financial market outcomes, which we firmly believe. For
now, household exposure to yield oriented vehicles such as bonds
is just not so far off of all time lows.
Although we and many others worry that ultimate reconciliation in the US trade imbalance of the moment could indeed remove an important support to the bond market that is currently purchases of US bonds assets by the foreign community, are the baby boomers the next buyers in what might become a frantic search for income/yield? Personally, we believe bonds are a terrible investment at present based purely on fundamentals, but it's this potential type of a demographic driven need that may override fundamental considerations for a time. Moreover, and more importantly to our investment activities, we sincerely believe there will be an increasing boomer driven bias for dividend yield. We've been preaching for years that total rate of return investing would be again important ahead. This set of circumstances we've laid out simply puts an exclamation point behind this thought. Is this an important set of considerations for the open of the market tomorrow morning? Nope. But perhaps does this highlight an investment theme of long term durability? We sure think so. And all driven by what has been household reaction to asset inflation, household liquidity diminution of the past few decades and the growing acceptance and apparent complacency regarding ever increasing leverage of the household balance sheet. You know and we know that real long term wealth is created in the investment process by identifying and participating in long term investment themes. If yield is not a long term and successful macro investment theme ahead, we'll be more that a bit surprised. All one has to do to make the secular case is have a good look at current household balance sheets. Funny, it's the one thing Wall Street doesn't seem to do very often. And maybe for a reason, do you think?
YEAR
2006 MONTHLY ARCHIVES
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Copyright ContraryInvestor.com © 2007