AUGUST 10, 2009
Debt Burden to Weigh on Stocks
Consumers' Inability to Drive Economic Growth Likely to End Big Gains
By E.S. BROWNING and ANNELENA LOBB
Economists are boosting growth forecasts. Employment numbers are improving. Manufacturing activity is bottoming. Housing demand is strengthening. Business leaders are starting to say the worst may be over.
Markets are celebrating, hoping the good news will keep on coming.
But there is a smudge on the picture. A surprisingly large number of money managers and economists are warning that, despite the hopeful signs, the economy is still deep in the woods, not strong enough to support a long-running stock and bond recovery.
The Dow Jones Industrial Average now has jumped 43% from the 12-year low hit March 9. It finished Friday at 9370.07, its highest close since Nov. 4. Risky credit investments, such as junk bonds and even mortgage-backed securities, also have been recovering.
"The question now is, 'Where do we go from here?' " John Osterweis, chief investment officer of Osterweis Capital Management, told clients in a recent report. "The simple answer is probably, 'Nowhere fast.' "
According to this view, the market surge of the past five months has been a celebration of the government's success in staving off financial doom. Stocks deserved to rise from panic lows. To keep rising in the future, the market needs a sign of real economic recovery, and that requires a surge in consumer spending, business investment and home buying.
That is what is in doubt, and one word explains why: debt. Despite an uptick in consumer saving, debt levels have only barely begun to come down. Even after the recession ends, economists expect the gradual reduction of the nation's massive consumer debt to take years. In the meantime, they are warning that the economic-growth surge expected for the second half of this year could be followed by slower growth and a softer stock market in 2010.
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A survey of six leading Wall Street stock strategists, ordinarily a bullish bunch, shows them on average forecasting the Standard & Poor's 500-stock index at about 1033 by year's end. Their forecasts range from 930 to 1100. The S&P 500 finished Friday at 1010.48, already nearly at the average forecast.
On Wednesday, in the wake of encouraging manufacturing and auto-sales data, economists at Goldman Sachs Group tripled their forecast for inflation-adjusted economic growth to a 3% annual rate for the second half of this year. And after that? They see the growth rate steadily declining to 2% in the first half of 2010 and 1.5% in the second half.
The debt data are striking. According to the Federal Reserve, total household indebtedness peaked at the end of 2007 at 132% of disposable income. That was by far the highest level since at least the end of World War II, nearly quadruple the 36% of 1952. By the end of March, with families boosting savings, repaying debt and defaulting, the ratio had fallen to 124%, a tad lower but still miles from the level of, say, 69% in the middle of 1985.
Consumer spending today accounts for two-thirds or more of economic output. But as they boost savings and cut borrowing, consumers can't be the drivers of economic growth that they were at the end of other recent recessions.
Consumer borrowing fell in June for the fifth consecutive month. The savings rate, which had fallen below zero in 2005 as a profligate nation spent more than it earned, was back to 6.9% of disposable income in May. It pulled back to 4.6% in June, but as people struggle to repay debt, many economists expect the savings rate gradually to return to the 7% to 10% range of the post-war years.
"Consumers are under significant financial pressure," Goldman notes in its report. "The weakness in household income -- partly resulting from the sharp slowdown in hourly wage growth -- will make it harder to raise saving without significant constraints on consumption."
As for home building and capital spending, two other possible growth motors, "we do not expect a 'traditional' rebound in these sectors, largely because the overhang of unused capacity in both the housing and business sectors remains enormous," Goldman said.
Morgan Stanley, Goldman's big rival, is on pretty much the same page. "We believe that the painful adjustments to household and corporate balance sheets that are likely, given the excesses of the past, are enough to make the economic recovery a slow and tenuous one over the medium term," wrote Morgan Stanley economist Manoj Pradhan in a recent analysis.
Nonsense! says Michael Darda, chief economist at brokerage firm MKM Partners in Greenwich, Conn., who bullishly and accurately predicted this year's huge rally in risky assets such as stocks and junk bonds.
"We continue to believe the consensus view of only 2% real [gross domestic product] growth for 2010 is far too tepid," Mr. Darda said in a recent report. He added, in another report, "The conventional wisdom has coalesced around the idea -- which goes virtually unchallenged -- that higher average savings on the part of households will ipso facto reduce the average rate of GDP growth during the impending recovery cycle."
He says the pessimists once again are ignoring clear economic and financial signals, such as the continuing recovery in the corporate-bond market, which typically precede a recovery in stocks and in the economy. He thinks doubters soon will have still more egg on their faces. And he has been right so far.
In an effort to make sense of the increasingly intense disagreement, Bridgewater Associates, an often-contrarian money-management firm that oversees about $72 billion in nearby Westport, Conn., has recently sent clients a series of reports.
Although the reports are complicated and detailed, their essence can be summarized simply. The optimists see signs that the recession is ending, and they forecast the normal next step: a stronger stock market. The pessimists believe the most important development isn't the end of the recession, it is the long process of debt reduction by families and businesses. Bridgewater lines up with the pessimists. It has been trying to avoid stocks tied to the U.S. economy in favor of those linked to the emerging economies of the developing world, notably China.
The bulls believe the economic and stock-market recoveries will continue to look like a V. The pessimists fear they will be more like a W -- or even a succession of W's.
"And remember that the up-leg of a V and the first up of a W look the same when you are in them," says David Kotok, president of money-management firm Cumberland Advisors in Vineland, N.J. He is betting that the stock market will keep doing well for a while, and then will suffer as the economy sputters. "The U.S. is not out of the woods by a long shot," he says.
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