The Debt Generation
Over the last 20 years a generation of Americans – the baby boomers – leveraged their personal balance sheets to a degree without precedent in the history of economics. At the same time, they represent an enormous future pension liability for the government. Porter Stansberry previews this looming economic crisis…one that will likely concern any observer of the American financial system.
Throughout history, even the most important and self- evident trends are often completely ignored because the changes they foreshadow are simply unthinkable…
Examples of big, problematic trends that the "elite" missed are too numerous to list here with any authority. But consider: did the massive inflation of the 1970s come without significant warning early in the decade? No one said much when Nixon untied the dollar from its gold peg in 1971. There wasn’t a huge outcry in the mass media against his price controls in 1972. And the rapid escalation of social spending coming from Johnson’s "War on Poverty" went without critical analysis until the mid- 1980s. Why did so few people see clearly what were huge and obvious warning signs of an enormous inflation?
Not all trends are bad, of course. But many still go unnoticed. Take the bull market of the 1990s, for example. The Netscape IPO that launched the mania occurred in the spring of 1995…five years before the market’s peak. Few people understood what was likely to happen. In his 1994 book, The Road Ahead, about the future of computer technologies, Bill Gates, doesn’t even mention the word "Internet."
The biggest trend we see in place right now can easily be captured in one word: debt. Since 1992, there’s been an ominous shift in debt from the public to the private sector. Federal borrowing rates have declined, while private borrowing has grown at a rate never seen before in America.
In 1992, the government borrowed around $300 billion; private industry borrowed $200 billion. Since then, private borrowing has increased every year except 2000 and now tallies over $1 trillion per year. Federal borrowing, as you know, declined until mid-2000 and was actually negative for a few years (indicating a Federal surplus). But, overall net debts – private and Federal combined – increased during the whole period, moving from around $500 billion per year in new debt to over $1 trillion per year in net debt addition.
A high rate of debt growth, by itself, is not necessarily a problem. If these funds are invested wisely, if they spur new economic opportunities, then, as a percentage of our national balance sheet, these debts could remain sanguine. But that’s not what has happened. Instead, since the 1960s, each new dollar of debt has added less than a dollar to economic growth. This indicates our economy is suffering from systematic declining returns. Today, each new dollar of debt adds about $0.54 to economic growth (that’s assuming the U.S. economy is growing at 2.5% a year – which it may not be).
The vast majority of the debts we added in the 1990s were used to fuel massive financial speculation in corporations and home mortgages. As these financial assets begin to deflate, the debt remains, causing the debt to loom higher and higher as a percentage of assets. Total debt, as a percentage of GDP, has grown from around 150% in 1982 to nearly 300% today.
Unfortunately, not even this high debt load tells the whole story of our future obligations.
As the bear market has ravaged the stock market, the assets of U.S. pension funds were annihilated. State and local pension funds – whose figures are a matter of public record – have fallen in value from $80 billion in 2000 to $25 billion today…a 70% decline. Although I don’t have complete figures for U.S. corporate pension funds, those numbers won’t look much different from the state and local government accounts (which often use the same pension fund managers).
Meanwhile, news of enormous future charges to earnings based on the mandatory contributions to their sagging pension funds are filling the pages of the financial media. For example, SBC announced this week it would take a $2 billion charge against earnings next year to begin repairing its pension plan. Raytheon says it must pay $500 million towards its pension fund over the next two years. Right now, Wall Street estimates that 10% of the S&P 500’s earnings next year will go towards underfunded pensions.
There is, of course, an even bigger underfunded pension plan out there – Social Security. But describing the future impact of these costs requires more detail than I can even begin to cover in a few paragraphs.
Suffice it to say, there are two components to private debts – corporate debts and personal debts. The rise of personal debt isn’t hard to figure out: who doesn’t like to live beyond his means? On the other hand, understanding why companies have abandoned all fiscal responsibility isn’t that easy.
Corporate managers have leveraged their balance sheets and used debt to manipulate earnings in order to increase profits, ‘grow’ earnings and augment the value of their stock in the short term. Stock option compensation gives managers an incentive to take big risks. If the risks work, the managers receive windfall profits. If they don’t, managers can walk away unscathed.
The worst abusers of shareholder trust aren’t hard to find. Just look at America’s biggest and most respected companies. IBM bought back $9 billion worth of stock while issuing $20 billion in new debt during Lou Gerstner’s reign as CEO from 1993-2000. Why would you issue debt that costs you 8-12% in interest when your stock only pays a 1% dividend? The only reason you’d do this is to juice earnings in the short term. In the long term, you’re only adding risk and shrinking your future profit margins.
But what did Lou care? He received 500 million stock options (all of which he sold when he retired in 2000). There’s no doubt that Lou Gerstner leveraged IBM’s balance sheet to increase its operating margin. That’s not against the law…but it’s not the way great companies are built. It’s the way great companies are devoured. Since Gerstner’s departure, IBM also admitted to booking asset sales as operating revenue – a common accounting trick to hit earnings forecasts. Selling assets is also another way to leverage your balance sheet. Within one year of Lou’s retirement, his replacement had taken huge billion-dollar charges, sold off major underperforming businesses (hard drives) and closed non-performing (but long held) businesses like PCs.
Unbelievably, Gerstner wrote a self-congratulatory book about his tenure at IBM. It’s being published.
Or how about GE, perhaps the most respected company of all time? Since 1992, GE has been a net borrower. How could America’s best company be a net borrower for ten years? Well, look at what the company is doing to make money, and it’s easy to figure out.
About 50% of the company’s total debt is in the form of short-term paper – the 90-day commercial paper market it can access thanks to an AAA rating by Moody’s. The company uses this debt, which carries a low interest rate, to finance credit cards, which carry a high interest rate. If you walk into J.C. Penney or Macy’s and take out a credit card, chances are pretty good that you’re on the hook to GE. In total, GE Capital has spent $43 billion on buying such receivables in the last three years alone.
And here’s the scary part. Fifteen times since 1997, the company has sold a large batch of these securities (at a loss?) less than three weeks before the end of a quarter. That’s how the company is able to match its earnings forecasts so precisely.
Meanwhile, GE’s debts have mounted. Today, its balance sheet stands precariously at four times debt to equity. Why take such risks? Because these debt-laden acquisitions accounted for 40% of GE’s revenue growth from 1985 to 2000, according to Merrill Lynch analyst Jeanne Terrile (who retired immediately after publishing her study of GE’s use of debt).
Again…these are America’s best companies. As profit margins slipped in the ’80s and ’90s, corporations leveraged their balance sheets to make profits look better. More sophisticated companies played more sophisticated games. And the whole time, fundamentals continued to deteriorate without any clearly discernible warning.
Since 1975, capital expenditures have exceeded cash flow, meaning that corporations have been raising debt or equity faster than profits. This game catches up to you as demand slowly declines. Eventually, capacity utilization rates begin to fall on everything from computers to credit cards, indicating a broad surplus of goods and services in our economy. And that’s what we see was slowly happening, starting as early as 1985 and accelerating with amazing rapidity over the last two years.
Across the board in our economy, capacity utilization has fallen from around 85-90% in 1985 to below 75% today, according to the Board of Governors of the Federal Reserve System. The data makes sense: areas of our economy that had the biggest investment boom show the biggest decline in capacity utilization today. Capacity utilization in electronics, for example, has declined from 90% in 1999 to under 65% today.
This rapid decline in capacity utilization is one of the symptoms of a credit bubble bursting. A healthy economy is driven by savings-fueled demand. When savings and investment become badly maladjusted, there will be problems. If you think of these problems in the abstract, they’re easier to understand. Imagine your own family’s balance sheet. What would happen if you maxed out every available credit source over the next six months? Your rate of consumption would soar, you’d place great demands on the economy and, eventually, your needs would slowly decline. You’d be left with few wants…and a lot of debts. You’d stop buying anything for a long time, until you were able to repair your family’s balance sheet.
That’s essentially what has gone on in America over the last ten years. The savings rate here declined from around 5% (which is weak) all the way to a negative figure in the late 1990s. People were spending more than they made each year, mostly by tapping into home equity loans. Now we’ve reached the point were most people (and most corporations) are close to tapped out.
The amount of money people have borrowed against the value of their homes is unprecedented. Since 1992, quarterly adds to home mortgage debt have increased from around $200 billion per quarter in 1992 to over $600 billion in the most recent quarter. This is an amazing amount of debt…
Take a look at the data we have on consumer credit, which includes auto leases and home equity loans. Back in 1992, consumer credit as a percentage of disposable personal income stood close to 16%. Today it’s over 25%. And that means an overwhelming majority of people’s income today is going towards taxes, interest and paying down debts.
Future demand is going to be weak…and could be for a surprisingly long time.
For the Daily Reckoning
November 26, 2002
P.S. 0n March 20, 2001, in response to the third Federal Reserve rate cut of that year, I wrote a piece called "Where Do Stocks Go From Here". Some analysts were putting out research showing that in the past, after three Federal Reserve rate cuts, stocks had always gone up. But that’s not what I concluded was likely to happen this time around.
"The last time stocks were this overvalued," I wrote, "and our economy was leveraged to this degree was the Great Depression. The third rate cut by the Fed (in February 1930) didn’t do anything to halt the collapsing stock market. Stocks fell another 41%. I continue to recommend that you own high quality, short-maturity corporate bonds. That’s where 91% of my assets sit today.
"When bonds yield more than 1.5 times stocks’ earnings growth, bonds outperform stocks by more than 5% on average…The most important thing for you to do is to realize that the size and duration of this recession is probably going to be bigger and longer than most people think." Eighteen months and NINE rate cutes later, the Prudential Short Term Corporate Bond Fund (to use one example) has gone from $11.16 to $11.34 while the S&P 500 has fallen from 1160 to a low of 779. Today it trades at 932, a loss of 20%.
Editor’s note: Porter Stansberry is the founder of Pirate Investor, publishers of high-quality investment research.
We checked our calendar. Thursday is clearly indicated as Thanksgiving. (Alas, here in the Paris office, we will be at our posts, unable to tuck in our turkey and cranberry-sauce substitute until the weekend, when the children are out of school.)
And there, on December 7th is ‘Pearl Harbor Day,’ and so on.
But even peeking ahead to the calendar for 2003, darned if we can find a date marked "End of the Wall Street Rally." It just isn’t there.
Investor’s Intelligence tells us that the professionals are encouraged. Seeing no end in sight of the bear market rally, twice as many advisors are bullish as bearish. And evidence mounts that ordinary investors are getting back into stocks, for the long run, of course.
What a pity if the end of the rally comes unannounced, unscheduled, and unexpected!
Poor Alan Greenspan. The former gold bug libertarian turned his back on his old friends and went over to the other side, becoming not merely a central planner, but THE central planner for the entire world economy and THE manager of the world’s most important managed currency. He must be getting lonely…and a little desperate. He’s cut rates a dozen times. But where is the "Strong Recovery" economists have been predicting for the last 18 months?
How he must suffer…as day by day his reputation wears down a bit more. And he still has 2 more years until retirement. Check the calendar; will the rate cuts have restored the economy by then?
Yesterday’s news brought more confusing and conflicting data. Houses are selling better than expected…with average increases of about 10% year to year – more than 4 times the inflation rate!
On the other hand, bankruptcies hit a record high in the third quarter. Personal debt passed the $8 trillion mark. And the number of foreclosures is rising about 3 times as fast as the inflation rate.
"Sometimes these companies throw the American dream in your face," the NY Times quoted a homeowner in Indianapolis whose appraisal was just reduced $20,000. "You get a fast-talking lender. I can see why normally level-headed people get sucked in."
Conseco is said to have 19,000 repossessed mobile homes it would like to get rid of. And the NY Times reporter found boarded up homes in many areas of Indianapolis.
Meanwhile, the National Association of Realtors estimates that baby boomers will buy 1 million 2nd homes in the next 10 years…and more than a few third homes, too. If only they would buy their second homes in Indianapolis. Or maybe a double-wide from Conseco.
But let’s hear from Eric on the progress of this wonderful bear trap…oops, we mean, bear market rally…
Eric Fry in New York City…
– The "retro" market keeps powering ahead. Like a real- time flashback to the bubble era, stocks seem to rise every day, especially tech stocks…and speculative tech stocks are rising most of all. Yesterday, the Dow picked up 44 points to 8,849, while the Nasdaq gained nearly 1% to 1482.
– It’s hard to believe, but in less than two months, investor psychology has shifted dramatically from fear to greed. In early October, the bear market seemed to be a permanent feature of the financial landscape, and no one scoffed at projections of Dow 5,000. Now, however, the angst of early October is a distant memory and optimism is once again in full-bloom. In fact, some corners of the stock market feel downright frothy.
– My friend, Michael Martin, a broker with R.F. Lafferty, walked into my office yesterday with a piece of paper in his hand and said, "Look at this!…Almost all of the most active stocks on the NASDAQ are selling for less than $10 a share…Buyers are going after the cheap stuff, the speculative stuff."
– I looked at the list and, sure enough, a highly speculative collection of bubble-euro flameouts topped the list of most active issues. Names like JDS Uniphase, Brocade, Ciena, Juniper Networks and Vitesse Semiconductor headed up the list of most active issues, as investors threw caution to the wind in hopes of making a big score quickly. The great thing about lowly priced, highly speculative stocks is that they can cover a lot of ground in a hurry – both to the upside and to the downside. But for now, it’s all upside, and the "dumb money" has never felt more brilliant.
– Yessiree, the speculative juices are flowing on Wall Street once again, which tells us that this bear market rally is probably just about over.
– "I know, I know, tech is rallying," writes Karim Rahemtulla, the mind behind the Forward Profit Strategy trading service. "But is the tech rally real? Sure, tech stocks are going up. But, are the shares worth the price they are selling for? That’s really the question that you should be asking. And when you ask, here’s the answer you’ll get. NO!
– "I don’t buy into this rally because it has absolutely no fundamental basis," Karim continues. "It is a ‘wish’ rally, and I am going to bet the wish will not come true."
– "All this time, we thought that Ebitda stood for earnings before interest, taxes, depreciation and amortization," Alan Abelson jokes in this week’s Barron’s. "Comes now an old friend to inform us that all these years we were wrong. What Ebitda really stands for, he contends, is earnings before investigation, termination, deposition and arrest."…Now we know.
– We’ll end on a sad note: Citing "difficult business challenges," America Online is canceling holiday parties for its 18,000 employees. Apparently life inside the former dot.com darling is not as festive as it used to be. How ironic. AOL was one of the most visible party- animals during that raucous two-year romp known as the "dot.com bubble." Oh well, you can’t party like a 21- year-old forever. Instead of an "elaborate holiday party," division head Jonathan Miller said that AOL will offer some rather sober-sounding "special employee socials." Hey, that sounds like a pretty wild time!…Will there be a quilting bee?
Back in Paris…
*** Stocks continue to rise. Gold goes nowhere. Which would you rather own? Most investors will take the stocks. Heck, they’re already up more than 20% since the bottom.
But here at the Daily Reckoning…and here we warn new readers…we try not to care too much about money. Like laying bricks or courting women, it’s best not to pay too much attention. Otherwise, you’re likely to make a mess of it.
We aim to do the right thing, not necessarily the smart thing. With no calendar indicating important future tops and bottoms, all we can do is to follow the essential principles. We don’t know what the smart thing is; so we do the right thing and hope it pays off. If it doesn’t, well…it ought to.
So we buy gold and sell stocks. Because the right thing for an investor to do is always to buy low and sell high. Stocks are high. Gold, by comparison, is low. And if gold goes nowhere…well, nowhere is okay with us.
Most often and eventually, we have observed, things go back to where they usually are. At the end of the Carter Administration, an ounce of gold traded for about the same price as the entire list of Dow stocks. That was an aberration, to be sure. But no more of an aberration than what happened at the end of the Clinton years – when it took 38 ounces of gold to by the Dow. Currently, an ounce of gold will buy only 1/28th of the Dow…with probably a lot further to go before things have reached normal.
*** Paris was especially beautiful last night. The big department store, Samaritaine, was lit up in pink for Christmas. Trees and lights of the holiday season have begun to appear. And everywhere, the wet streets bent the light back up towards us, skewed by decaying leaves and cobblestones.
Maria, 16, took her father’s arm as the two of us walked down the Rue Jacob.
"Daddy, my agent says I should relocate to New York. He says that this is my big chance…
"Models don’t get many chances. You have to take it when you have it. I’m a little young, I know, but Véronique told me too that this is the perfect time. I’ve made the rounds in New York already. They’re starting to know me. I have to be there when they ask for me."
"I don’t really want to leave home, though…It just feels like all of a sudden I can’t be a little girl anymore. That makes me a little sad…like I won’t be part of the family anymore, except on holidays…" "Uh huh…"
"But a lot of the girls are like that, even those who are younger than me: I know a couple who are only 15. They’re from Russia, I think. They’ve been on their own for more than a year. They only see their families once a year. And their parents can’t afford to come visit them.
"Still, they seem to do okay. I mean, they seem happy…
"One of them got to be really successful. She made a lot of money, got a nice apartment and sent her mother a ticket to come to visit her…
"But most of them just sort of get by…it’s kind of sad…"
Later that evening, after dinner, Elizabeth asked:
"Well, what do you think? Do think Maria is ready to move to New York…?
"She seems ready…" your editor replied, wondering whether he was ready.