Where is the consumer?

This is unprecedented. The fact is that we have never seen a consumer lead recession in our lifetimes. The previous recessions in 73/74 – Oil; 80/81 – Interest Rates; 90/91 - S&L crisis; 2001 - Dot-Com collapse and 9/11 were all exogenous shocks to the economy that resulted in a contraction in business, but were not consumer lead. Every facet of the economy has enjoyed the pearls of leverage over the last 20 years. We were all operating at levels that were not warranted, levels that were sustained only by leverage on the household balance sheet. In order to pay this debt and get the household balance sheet in order, people have to work more jobs, spend less, and save more. Also, the unemployment rate after bottoming early last year at 4.4% is now close to 6.1%; this can easily go to 8-11% if history is any guide. Personal income drives consumption and with unemployment rising, personal consumption will go down. Furthermore, in all likelihood Senator Obama will become President of the United States; and he has talked about ‘taking responsibility’ and ‘saving’ etc. This is in stark contrast to the current administration’s message of ‘spend, it’s the American way’.

The US consumer on average has a disposable income of $10 trillion/year and the saving rate over the last few years has been negative. If we look at the 25 years ending in 1985, the saving rate was 10%. I believe the savings rate would go up substantially; maybe not 10%, but something like 5% over the next 5-10 years and factor in the absent leverage – the consumer (75% of GDP) will be a huge drag on the US economy. I believe that were will be smaller engines in the form of Asian economies (slowing down) but the net result will still be negative - via a negative feedback loop. Now the economy either needs: 1) A Large War 2) Major Technology breakthrough. I place a very low probability of any one of them occurring. In essence, this will be a consumer led recession, is unique, will by all accounts severe and last a long (3-4 years) time. We know that the economy and the stock market are rarely in sync, but as an investor this matters because it is crucial to know where the consumer is when valuing a company.

Warren Buffett in a Fortune magazine article once argued that if there is one indicator he looks at, it is the ratio of the market capitalization of the market to the GNP (I am using revenues). The current P/S ratio of the S&P 500 is 1.22. The current ratio sits above the long-term average of 1.14 since 1975 and the median of 1.10; and is substantially higher than the ratio reached in the 1990 bear market of 0.77 and in the early 1980's of 0.50. There has been however, a permanent upward shift in the level of profitability (although the profit margins of 2006-2007 are unsustainable) in the economy, and the S&P 500 should be able to maintain a relatively higher price to sales ratio. S&P 500's median P/E ratio now is at 13.5 and has fallen to just below its long-term average of 14 and below its median of 15. It's near the valuation levels reached in 2002, but remains noticeably above the levels reached in 1991 - 11, in 1982 - 7 and in 1974 - 5. Taking the P/E and the P/S ratios into consideration the market has further to fall - S&P around 750-800; and might trade flat to down over the next few years with a few bear rallies. There are no predictions, only probabilities. I believe in buying stocks and not markets. Balance sheet strength is as important as ever, and investors should buy stakes in stocks they are prepared to average down on. Although I strongly believe in fundamental bottom up analysis (90%), I think it is essential to have a perspective on the relative valuations (10%).

Update: GMO's Jeremy Grantham has completed the first part of this Quarterly Letter, very interesting commentary. He essentially said that they are nibbling right now, they might be early and that there is risk of a 20% overrun to the downside.