MARKET OBSERVATIONS

Counting Cards

MARKET OBSERVATIONS - 6/20

It's The Time Of The Season...Despite what we hope will be a wonderful summer for all of our readers, it looks like an early winter may be coming to credit land for a number of financial institutions.  As we told you last week, the Fed is out with its Flow of Funds Report for 1Q 2000.  As if right on cue, Wachovia Bank celebrated the report's release with a little release of its own.  For poor Wachovia, it was a little release of pent up market capitalization from its own little gaseous bubble.  In all seriousness, the report from Wachovia last week that it is upping internal reserves for potential credit losses is most important.  Why?  Wachovia is one relatively conservative operation.  Moreover, past patterns of loan/credit reserve activity at Wachovia have tended to be correct and early in predicting a turn in the credit cycle.  We, for one, are listening.

The Bomb's Bursting In Air...Not to be outdone by Wachovia in upping credit reserves, Union Bank of California came out last Friday and said that it also was following down the Wachovian path of prudently adding to reserves.  As you would imagine, modern day "investors" dutifully marked down Wachovia and UB's stock prices by roughly 40%, give or take a few hundred million in collective market capitalization.  As you know, sympathetic spillover carried to the entire banking group.  After marking up most banking issues in the last three weeks on the certainty that the Greenspan crew was done fiddling with interest rates, most bank issues gave it all back and more last week as young mutual fund portfolio managers far and wide were painfully informed that banks can actually have potential exposure to credit losses.  Live and learn.  What a tragedy to shatter such new era innocence.  

We suggest you keep a sharp eye on further developments in bank lending land.  It's been a good while now since credit quality has become an issue.  We had a brief scare a few years back around the time of the LTCM "crisis" (turned buying opportunity - thank you AG) where a number of banks wrote off chunks of hedge fund "paper", but real world credit losses have not been an issue broadly...until now.  This could be the beginning of a real turn for the banks in terms of capacity and willingness to lend.  

Why is this so important?  Two reasons.  One, as we will discuss further in a few minutes, we are counting cards in terms of who is able and willing to provide credit into the financial system at this time.  In our minds, credit has been the lifeblood of financial asset mania over the last half decade or so.  By counting the suppliers of that credit and identifying change at the margin in terms of their ability to supply that credit in the future, possibly one can get a sense for the direction of asset prices down the road.  The second reason we view credit trends at the banks as so important is that the banks have historically tended to be extremists.  As recently as the early 1990's, banks went from a lending philosophy of "anything goes" to no lending for any reason.  With today's stock option incented bank managements, just how philanthropic do believe their lending practices will become when they all of a sudden experience "shrinkage" in their bottom lines and stock prices?  Banks have a history of turning the spigot off completely until the "coast is clear".  That certainly would not bode well for the credit dependent personal consumers and financial markets of the new economy.

All This Time, The River Flows.  Endlessly, Like A Silent Tear...The flow of credit in our financial system during the last five or so years has been an incredible support to financial asset prices in the US.  In our minds, the support.  That's why every time the Fed's Flow of Funds report hits the Street, we try to drag you through the factual mud.  The latest report just happens to reveal a good bit of incremental change.  Let's get right to the numbers.

We can't know where we are going without knowing where we've come from.  The following chart is a broad overview of debt outstanding in the US financial system today:

Domestic Non-Financial debt includes government debt, household debt (consumer credit, mortgages), corporate debt and state and local govt. liabilities.  Financial sector debt speaks for itself.  It's the debt taken on by financial intermediaries.  As you know, you do not add these twin views of outstanding debt together to get total debt.  Much financial sector debt has been taken on to provide credit to the non-financial sector.  Earning the spread, if you will.  We conservatively view domestic non-financial sector debt as total debt in the system.  This is a very conservative stance.

Although it may not be readily apparent upon casual observation of the chart, what we believe is the most important message is the acceleration in financial sector debt relative to total debt over the last 20 years.  More so the acceleration since 1995.  Since 1980, total US debt has grown 450%.  Financial sector debt has grown 1340% over that same period.  Since 1995, total US debt is up 135%.  For the financial sector, it's 202%.  Unquestionably, the business of financing debt is big business in the US.  It's this financial sector that we believe is so important for monitoring purposes ahead as it has clearly been the primary source of incremental credit creation at the margin over this entire new era bull market period.  We would theorize that change in financial sector credit creation will have a direct effect on financial asset prices over a reasonable period of time.

Economics 101...Demand versus supply is really the key to the pricing of any asset, now isn't it?  Simple premise.  Forget P/E's, interest rates, etc.  Before looking at the crucial component of supply, let's take a minute and look at demand in 1Q of this year.  The FOF report clearly shows that the only two components of credit demand to register double digit growth rates (annualized, of course) in the first quarter of this year was consumer credit and corporate debt.  In absolute dollars, mortgage debt is a big deal, but in terms of growth rate, corporations and consumers stole the show:

The use of corporate debt to finance stock buyback programs simply needs no explanation.  From our vantage point, it has become the single greatest transfer of wealth from shareholders to employees in US corporate history.  The ironic part is that shareholders just don't seem to realize it...yet.  When the music stops, the stock options belong to the employees.  The balance sheet belongs to the shareholders.

The chart of annualized growth in US consumer credit is quite interesting.  Following the slower economy and the corporate cost rationalizations of the first part of the 1990's, consumers naturally ramped up credit demand as job security settled in mid decade.  The mid decade fall off in growth rate displayed the fruits of increased employment.  There is no question in our minds that the late decade spurt in consumer credit growth is directly related to the perceived wealth effect of the stock market and the new era economy.  If it's not the stock market effect, then why would consumers need to ramp up credit consumption in the face of the lowest unemployment rate in decades, nice wage gains, and the extension of lucrative corporate goodies such as stock options?  Let the good times roll.

As you know, this data reflects the first quarter.  Both consumers and corporations had not yet experienced the NASDAQ "buying opportunity".  We have seen anecdotal evidence since of slowing retail sales on the part of the consumer.  Likewise, if corporations loved their stocks at higher levels, shouldn't they be drooling over the chance to buy back stock at much lower levels?  Strange that we haven't seen many new buyback announcements recently.  

Counting Cards...What happens to corporations and the consumer in 2Q may just be a function of counting cards.  Counting the suppliers of credit, or rather the suppliers own demand for credit to finance their intermediary function.  In the very infrequent times we find ourselves in the vicinity of a Reno or Vegas casino, we only have the stomach to play single deck blackjack in terms of serious gambling.  Why?  We can count the cards.  As in common stock investing, we want the risk reward to at least be 50/50 if not better.  Whenever we see chain smoking senior citizens throwing our Social Security tax payments into slot machines, we need the stock market investing risk reward equation to be more in our favor than ever.  That's why we want to count the cards in terms of credit creation.  The 1Q Fed Flow of Funds report reveals an interesting twist this time around.  Quarter by quarter, over the last ten years, domestic financial institutions have taken on ever higher amounts of debt...until now.  1Q revealed a pretty hefty drop in the annualized debt taken on by financial institutions.  Have a look at the following table that reveals new debt taken on annually by this sector and the annual growth rates of that debt over the last ten years:

Clearly there was a change in 1Q.  Is it that domestic financial institutions have stretched their balance sheets to the breaking point?  Have we reached the point of debt accumulation exhaustion for the financial sector?  What ever the reason, this just may be the start of a slowdown in finance sector debt growth.  If that is true, credit to other parts of the economy extended by this sector may also be in for a change of pacing.  Remember the first graph we showed.  The finance sector has accounted for an ever increasing amount of total debt accumulation over the last ten years.  This says that maybe the financial sector has played the bulk of the face cards in the single deck game of credit creation blackjack.  We're counting.

We have ranted and raved that the GSE's (government sponsored agencies) have been responsible for huge amounts of financial sector debt and ultimately credit extension over time.  Especially the last two years.  Well wouldn't you know it, they've taken their foot off the accelerator.  Have a peek:

As you know, this happened before Treasury Undersecretary Gary Gensler began the government agency balance sheet bashing campaign.

Combine the recent Wachovia/Union Bank Cal loss provision experience with the clear (at least for now) slowdown in overall financial sector debt creation and it appears that these twin sources of subsequent credit re-creation are losing their previous positions of prominence.  If we are running out of face cards and aces in the ultimate game of credit creation, is it really time to for investors to increase their bets (on financial assets)?  Our vote would be that it's time to walk away from the table.  The risk reward equation in terms of increased credit creation being able to sustainably prop up financial asset prices seems to be turning negative.  Remember that it's change at the margin that counts the most.

Broker Of Last Resort?...Crazily enough, in 1Q, it was the broker/dealer community that attempted to pick up the financing slack in the credit markets.  As you know, margin debt simply shot through the roof in late '99 and early '00.  Record numbers.  If you lend it, they will come?  Apparently so.  Have a look at the following table to see how reliable broker/dealer credit extension has been over the years.

These annualized numbers for 1Q 2000 have no parallel anywhere in the last 6 years.  There is simply no question in our minds that this subset of the financial sector is simply the most fickle in terms of both borrowing and lending into the general credit markets.  When it comes to counting cards, this sector is the joker.  As you know, at the very first sign trouble, the willingness of this sector to accept and extend financing vanishes without a trace.  Can the general market really count on the broker/dealer community to pick up the financing slack seen in the other important components of the broader domestic financial community for any real length of time?  Fat chance.      

In spite of the effect of mutual fund/institutional investor activity at the end of this quarter, the 1Q Fed Flow of Funds Data suggest that the texture of credit creation in the US financial system is changing.  Credit creation has not stopped by any means, it's just that the most vehement providers of the last few years are pulling back.  Combine this with the recent news from the banking system and it spells change.  For those who have been following the numbers, this is just the first hint of change.  It will be important to monitor ahead.  We've said it too many times already, it's change at the margin that is the most important to identify.  It just may be that this recent Fed report is one big head's up.  Maybe a secular head's up.

Home, Home On The Range...Where the bear and the antelope play?  No doubt that the bear is playing with us.  Conversely, maybe it's the bull.  The S&P and the Dow have clearly been range bound for a while now.  A breakout in either direction will most likely be violent.  We'll just have to see whether we head north or south in the weeks/months ahead.  Here's Tim's chart de jour indicating a pretty classic potential head and shoulders pattern in the Dow forming.  Possibly completing the right shoulder as we speak.  But, as you know, given the characteristics of this market, we clearly do not want to speak too soon: 

We've mentioned over the last few weeks that we expected stock mark-up activity as quarter end approached.  So far the NASDAQ has acted as we had suspected.  The Dow and the S&P less so...so far.  One would naturally expect the NAZ to be acting up as this is where a lot of the mutual funds and institutions have big exposure.  The kind of exposure that virtually ensures that they were unable to liquidate significant size during the "correction".  If you can't beat 'em, jam 'em.  If you can't sell 'em, might as well ram 'em.  The so-called recovery in the NASDAQ so far has been characterized by relatively light volume.  Additionally, selectivity reigns supreme.  Intel and a good number of the broader semi crowd have made new highs while the NASDAQ is more than 1000 points below its old high.  Until proven otherwise, it still seems to us that these are the hallmarks of a bear market rally.     

Copyright 2000, ContraryInvestor.com