Investors in grave danger of chasing rainbows

SERIOUS MONEY:Bulls seem impervious to the dangers the US economy faces, and have pushed stock prices into overvalued territory once again, writes CHARLIE FELL

HAPPY DAYS Are Here Againwas the theme song for Franklin Delano Roosevelt's successful 1932 presidential campaign. The United States was deep in the throes of the Great Depression during the summer of 1932 and the major stock market averages had dropped by more than 40 per cent since the beginning of the year, for a cumulative loss of almost 85 per cent from the peak registered during the heady days of 1929.

Stock prices bottomed in June at levels first reached more than six decades earlier. Then they more than doubled within three months, as investors counted on a turnaround in the ailing economy’s fortunes.

Roosevelt's adopted campaign song first appeared in the 1930 film Chasing Rainbows. Two years later as FDR used the tune, investors imitated the movie's title.

The stock market bounce quickly ran out of steam as it became clear the economy had not bottomed, and the major market averages lost almost 40 per cent of their value from their autumn peak through the early months of 1933.

The current stock market advance of more than 65 per cent from the lows last March is the most rapid rebound in prices since the autumn of 1932, but could the current generation of investors be chasing rainbows just like their predecessors?

The US government has provided more than $10 trillion of guarantees, cash injections and other supports during the so-called Great Recession, or an amount equivalent to almost 75 per cent of GDP and, though a repeat of a 1930s-style meltdown has been averted, the growth registered during the third quarter of 2009 following a string of declines, was simply pathetic.

The economy advanced at a paltry annualised rate of 2.2 per cent after four consecutive quarterly declines that saw real GDP drop at a 4 per cent annual rate. This is the smallest rebound off an economic trough in the post-second World War era despite all the government assistance, and is a full five percentage points below the average registered during the first quarter of the previous 10 economic recoveries.

The perennial bulls will undoubtedly argue that current data suggest the economy advanced at a 4 per cent annualised rate during the fourth quarter but this reflects primarily a sharp slowdown in the pace of inventory liquidation. The major components of real private domestic demand – consumer spending and business fixed investment – remain soft and face significant headwinds in the months ahead.

Decades of excessive borrowing have left the household sector with an onerous debt burden that will limit consumer spending for years to come. The growth in household debt consistently outpaced disposable income growth from the mid-1980s until recently, and the ratio of debt to disposable income jumped from 65 per cent to an all-time high of 136 per cent in the fourth quarter of 2007.

The excessive growth in debt was accompanied by a dramatic decline in the personal saving rate – from more than 10 per cent in 1984 to below 2 per cent in 2007. The combination of higher household debt and lower personal saving allowed personal consumption expenditures to grow faster than disposable income, providing a significant boost to economic growth over the period.

Consumption cannot grow at a more rapid pace than income indefinitely, and the surge in delinquencies in recent years revealed that household debt was simply too high.

Deleveraging has begun and the ratio of debt to income has dropped to its lowest level in four years, but a double-digit unemployment rate and weak income growth have made it difficult to pay down.

Indeed, much of the improvement in the debt ratio can be attributed to the write-off of delinquent debt!

The deleveraging process is clearly at an early stage, and to reduce the debt ratio to where it stood just eight years ago by the end of 2011 would require household debt to contract at nearly twice the rate that disposable income grows.

The non-financial corporate sector began a process of deleveraging following the economic recession and infamous accounting scandals of 2001/2002 but balance sheets are not as pristine today as the bulls seem to believe. Non-financial corporate debt to net worth stood at 55 per cent in the third quarter of last year, as against a low of just 39 per cent in 2006, and a peak of 52 per cent in 2001.

These figures do not include the substantial defined-benefit pension deficits apparent at most major industrial companies. Not surprisingly, more than one-in-two issuers of corporate credit is considered junk by the rating agencies today. In this context, it is difficult to see the corporate sector being the engine of growth in the months ahead.

Private sector deleveraging has barely begun yet the total debt position of the United States has deteriorated considerably due to unprecedented government assistance. The outstanding debt of the household and non-financial corporate sectors at almost $24 trillion is equivalent to 173 per cent of GDP and, though the level of debt outstanding has dropped by $300 billion, the debt ratio remains at record levels.

Meanwhile, the outstanding debt of federal, state and local governments has jumped from 52 per cent of GDP two years ago to almost 70 per cent today. The government has used up its fiscal spare capacity and a further downturn could prove disastrous.

Investors seem impervious to the dangers that the US economy faces, and have pushed stock prices into overvalued territory once again, albeit modestly. Zero interest rates have contributed to an echo bubble that sees the major indices trading on 18 times long-term earnings power today, as against a long-term average of 16.

Excess liquidity may lead to further gains in the months ahead but investors would be well advised to stop chasing rainbows and reduce exposure into strength.