Giving Credit Where Credit Is Due

Posted by on 08/27/10 in America, Debt, History, Markets, Risk

In 1985, a visitor to China strolling about Beijing or Shanghai could expect to see in a day perhaps 10-20 cars struggling to make their way through a phalanx of bicycles and streaming rivers of pedestrians. Now Beijing struggles with almost perpetual traffic jams involving tens of thousands of vehicles that may be stranded on the highway for days—even weeks.

Situations like this make statisticians salivate. How intriguing, they think, to understand these jams. Are they random? Are there causal factors that can be identified and even managed? In short, what is happening? We can’t help but ask similar questions, not about cars in China, but about leverage in America.

1. Why can’t we return to the stock market growth rates of the 1980s, 1990’s, and into 2007?
While we would like to think that stock market growth during those nearly 30 years was primarily due to productivity gains, technological innovation, and good ol’ American know-how, we think that much of that stock market growth was due to the massive increase in our country’s leverage at the exact same time. Heresy? Perhaps. But if we are correct, then investors need to rethink expectations for stocks going forward.

Chart I below compares the growth of the S&P 500 (large US company stocks) to the growth of Public Debt (Federal), Consumer Credit, and Mortgage Debt from January 1976 to June 2010. Syntrinsic has added a “Smoothed S&P 500” line that mitigates the volatility of the S&P from 1994 to the present, so we can better see the general S&P 500 trend excluding extreme market noise.

Source: Treasury Direct, Federal Reserve, Bureau of Economic Analysis

The Debt is almost perfectly correlated to the Smoothed S&P 500, with correlation between them of 0.99. It could be coincidence, but we think such a strong relationship indicates something more important. While there has been a lot of noise over the past 35 years (fall of USSR, emergence of internet, rise of China, rise and stagnation of Japan, NASDAQ bubble, 9/11, Iraq, Afghanistan, housing crisis, etc.), leverage is a prime suspect in driving stock market growth during this period.

Just to emphasize how much our country was increasing its use of borrowed money, during this period leverage grew at a rate of 4.8 times the concurrent rate of inflation.

Based on the relative growth of Debt and the S&P 500 during this period, the Debt could be responsible for 50 – 60% of the stock market’s increase. If we were to factor in growth in municipal and corporate debt, the role of leverage would be dramatically higher.

2. But wasn’t our strong stock market of 1981-2007 due more to robust domestic growth than to leverage?
We wish that it were so; however, we think that domestic growth had a less significant impact than the increase in leverage. Chart II below compares the growth of the S&P 500 to the growth of America’s Gross Domestic Product (“GDP”). GDP is an imperfect measure of the economy, but it is the most comprehensive imperfect measure we have. Importantly, it includes much of the growth due to the increase in real estate values.

As with leverage, the smoothed stock market grew as GDP grew with a correlation of 0.99, (remember, perfect correlation is 1.00). However, the stock market grew 3.7 times faster than GDP grew during that period. Accepting that the correlation metric means something, then it would seem GDP is responsible for about 25% of the stock market’s growth. When we factor in the erosive effect of inflation, then the GDP growth rate falls to about 2.5% per year and GDP’s role in stock market growth drops below 10%.

The information below summarizes the annualized returns of these measures. Note that the sum of the annualized growth of Real GDP (Nominal GDP less CPI) and Public, Consumer, Mortgage Debt is quite close to the annualized growth of the S&P 500 (11.41% v. 10.66% per year); unfortunately, Debt represents over 78% of that sum.

Annualized Growth (Jan 1976 – June 2010)
S&P 500 = 10.66%
Public, Consumer, Mortgage Debt = 8.91%
Nominal GDP Growth = 6.55%
Inflation (CPI) = 4.05%

3. But aren’t we in a Great Deleveraging?
Nearly two years ago we wrote that we were in the midst of a Great Deleveraging, that it was time to rise up and spend down our lavish ways, unwind our collective exposure, and get back to basics—or something like that. Indeed, consumers have stopped increasing our leverage. Since the end of 2007, consumer credit has been stalled out at around $2.5 Trillion and Mortgage Debt has been stuck at about $14.5Trillion.

However, since December 2007 we have grown our country’s Public Debt from $9.2 to $13.2 Trillion, thus increasing the sum of our Public, Consumer and Mortgage debt from $26.3 Trillion at the end of 2007 to just shy of $30 Trillion as of June 2010. In short, we are not in a Great Deleveraging.

4. But if we are continuing to increase our leverage, then why is the stock market still about 25% below where it was in October 2007?
There are many reasons, but let’s consider investor sentiment and the how our leverage has been growing. Assume that 2008 was a shock to most investors and that people generally become more wary of the role of leverage. Certainly, there emerged for many an appreciation for the critical role that consumer credit and mortgage credit had played in America’s historically robust growth during this period.

But that is not the kind of debt we have been increasing; we have only been increasing our public debt. Increasing public debt at such massive levels has been sparking worry and fear, not consumer or investor confidence. Whether you embrace Keynes or Hayek, and whether or not you think the investing public is intelligent, investors are signaling their generalized anxiety about the potential affect of borrowing and printing more money. Thus, unless something enables consumer or mortgage borrowing to reengage, it is hard to see what would cause the market to rise materially.

Soon after news of Beijing’s traffic jam hit the international press, China’s state controlled media reported that the massive gridlock had mysteriously disappeared. Headline changed—problem (apparently) solved. Ah, that it would be so easy to solve an intractable transportation problem or to address our economic challenges. But just as the Chinese must at some point face up to a legacy of poor urban planning, corrupt officials, and a dishonest media, we in America must at some point look at our economy with more realistic eyes and not fool ourselves into believing in past economic glories or some sort of perpetual economic superiority.

It’s difficult to realize that what we had thought was a golden age economically was perhaps just a period of decent growth consistent with historic norms but juiced by leverage. But that realization should serve us better going forward than pretending otherwise.