Chapter two was the end of the home price bubble

Chapter two of the book was the end of the home-price bubble, and I would date that to the first quarter of 2007 when the Case-Shiller Index began to deflate year over year. Now, I want to make this point, and I want to make this point emphatically. Home prices in this country on average rose 20% per year for six years. That has never happened before. When you take a look at home prices in real terms, they’re still more than 30% higher today than they were when this mania morphed into a bubble back in 2001. So to those people who are thinking that we’re only 5% away from the low, I’d say I don’t think so. Make no mistake that there is going to be more deflation in home prices ahead – I think significant deflation – just as Freddie Mac put us on notice yesterday.

Chapter three was the end of the credit cycle

The third chapter was the end of the credit cycle, which, again, I would tag at exactly a year ago. I think the way we have to look at this, and we’re talking about how this affects our ability to navigate the portfolio and manage the macro forecast. This cycle saw the end of a 20-year secular credit expansion that went absolutely parabolic in the last 6 years and accounted for half the growth in just about every segment that’s forecast.

Chapter four was the end of the employment cycle

This is very big stuff and it’s taking on different forms. We have the end of the credit cycle as chapter three. Chapter four was the end of the employment cycle, which I discussed earlier, which started in December of 2007.

Chapter 5 is the first consumer recession since 1990-91

We’re heading into chapter five, and chapter five is the onset of the first consumer recession since 1990-91. I would argue this could end up being very similar to that six-quarter consumer recession that we endured from 1973-75. There are differences, but there are similarities. A lot of people like to compare this to 199091, because of the real estate flavor and the credit crunch, but there is actually a lot more going on that compares it to 1975.

I was around in the 1980s, and I remember that it played out very similarly. What people called resilience and people called contained and people called decoupling were all very pleasant euphemisms for lags. That’s what they are; they’re lags. There are built-in lags. Housing peaked in 1988, rolled over, the credit crunch intensified in 1989 when RTC got into real action. Then 1990 … two years after housing peaked, we had this very surprising consumer recession that caught even the Fed off guard.

The Four Horsemen

I wrote a report late last year titled The Four Horsemen. It was a regretful choice of words, because I kept on fielding questions as to whether or not I was, in fact, calling for the end of the world. I got to a point where my answer was “Just wait; it’s going to get worse than that.” In any event, who are the four horsemen? The four horsemen are credit contraction, deflation of both housing and equities, and that happened in the mid-1970s. Usually you’ll get one or the other. To have both housing and equities deflate on the household balance sheet, we’re talking about $30 trillion of assets. Half the assets on the household balance sheet are compressing dramatically right now. That last happened in the mid-1970s. We got credit contraction. We got deflation on the asset side of the household balance sheet that’s forcing the savings rate higher. We have employment, which I mentioned before.

Of course, food and energy – and, again, not just energy, but energy and food – and food is a bigger deal. Food is 15% of the household budget; energy is 10%. That’s a quarter of the household budget constrained by food and energy. Food is going to come down at a slower rate than energy will, but it’s already too late.

Oil prices are going down because demand is going down

People are saying to me all the time, “Gee, aren’t you going to turn more bullish with oil prices going down?” Well, oil prices are going down, because for the first time in this cycle it took $145 to break the back of the consumer. Quite amazing that it took that long, but it has happened. So we’re seeing true demand destruction in energy at a rate we haven’t seen in almost two decades.

It’s something to get an oil price decline that’s predicated on a new oil supply. I would keep that as a de facto exogenous tax cut; but when you’re getting oil price declines because of recessionary pressures cutting into energy demand, it’s no different than what happened in late 2000. That was the last time we had oil peel off as much as it is right now. I think it would have been a bit of a mistake for the economists at the end of 2000 to say, “Ah-ha, oil is coming down; I’m going to raise my 2001 GDP forecast.” You have to take a look at the reason why oil is going down, and the reason is not because of supply. The reason is because consumer demand is starting to go down. Again, the last time you had food and energy deviating so much from the long-run norm was in the mid-1970s.

Cash flow drain to household sector is $800 billion

When I take a look at the four horsemen and I try to come up with a number, the number I’m trying to come up with is a cash flow number. What is the cash flow drain on the household sector from the four horsemen in the coming year? The answer is $800 billion. So Uncle Sam, give me six more of those tax stimulus plans. That is a huge number. It’s equivalent to 12% of discretionary spending, which, by the way, is exactly the peak-to-trough decline in real consumer cyclical spending back in that 1973 to 1975 recession. The S&P 500 goes down peak to trough not by 20%, but more like 40%.

Three markers to turn us bullish

In terms of what are some of the markers that I’m weighing down to turn more bullish? I think this is very important. I look at not so much where am I going to be wrong, but looking at what are the things that will turn me more positive? There are three markers that I have laid down. The first marker is the personal savings rate. I have to see the personal savings rate go back to the pre-bubbles, normalized levels, which was 8%. I’m not talking about the Jurassic period here. I’m talking about where we were in the late 1980s and the early 1990s, before the last two bubbles. That’s why I said plural.

We had a tech stock bubble followed very quickly by a housing bubble. This had tremendous implications for perceived net worth and perceived future asset growth of the household sector. It had monumental impact on how people spent their after-tax income. That’s why we got to a point last year where briefly the savings rate got to negative for the first time since the 1920s. There was a belief system that we could retire on our assets, and now these assets are deflating and people’s expectations of how they’re going to retire is going to force that savings rate higher. That’s going to be very disinflationary, by the way.

I think it’s important to note that, in 2002, as the tech sector was deflating, Greenspan and Bernanke decided that it was a good idea to re-slate the housing stock as an antidote to the deflation in the tech capital stock. This is almost a piece of Mary Shelley’s Frankenstein; we built the monster, now we have to tear it down. I don’t know what else is left. We’ve had an equity bubble followed by a housing bubble, followed by a credit bubble. I don’t think there are any more rabbits in the hat to create the next bubble, unless that bubble is going to be in Treasuries, and maybe that is, in fact, going to happen. It’s pretty clear that the Fed is going to be concentrating a lot more in the future on non-traditional measures to ease monetary conditions, and not just cutting the Fed fund rate. Part of that may be reflating by expanding its balance sheet, which means that it’s not just talk. The Fed is actually going to add to its balance sheet, and that’s exactly what happened.

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