2012Jan23 Deleveraging-How Much?

Economy:

 

From 1990 to 2008, US private-sector debt rose from 148 percent of GDP to 234 percent. Household debt rose by more than half, peaking at 98 percent of GDP in 2008. Debt of nonfinancial corporations rose to 79 percent of GDP, while debt of financial institutions reached 57 percent of GDP.

 

Since the end of 2008, all categories of US private-sector debt have fallen as a percent of GDP. The reduction by financial institutions has been most striking. By mid-2011 the ratio of financial-sector debt relative to GDP had fallen below where it stood in 2000. In dollar terms, it declined from $8 trillion to $6.1 trillion. Nearly $1 trillion of this decline can be attributed to the collapse of Lehman Brothers, JP Morgan Chase's purchase of Bear Stearns, and the Bank of America-Merrill Lynch merger. Since 2008, banks also have been funding themselves with more deposits and less debt.

 

Among US households, debt has fallen by 4 percent in absolute terms, or $584 billion. Some two-thirds of that reduction is from defaults on home loans and other consumer debt. An estimated $254 billion of troubled mortgages remain in the foreclosure pipeline, suggesting the potential for several more percentage points of household debt reduction as these loans are discharged. A majority of defaults reflect financial distress: overextended homeowners who lost jobs or faced medical emergencies and found that they could not afford to keep up with payments. Low-income households are affected most by defaults-in areas with high foreclosure rates, the average annual household income is around $35,000, compared with $55,000 in areas with low foreclosure rates.

 

Up to 35 percent of US mortgage defaults, it is estimated, are the result of strategic decisions by borrowers to walk away from homes that have negative equity, or those in which the mortgage exceeds the value of the property. This option is more available in the United States than in other countries. In 11 of  50 states-including hard-hit Arizona and California-mortgages are nonrecourse loans. This means that lenders cannot pursue other assets or income of borrowers who default. Even in recourse states, US banks historically have rarely pursued nonhousing assets of borrowers who default.

 

US households could face roughly two more years of deleveraging. As noted above, there is no accepted definition of the safe level of household debt, which might serve as a target for deleveraging. One possible goal is for the ratio of household debt relative to disposable income to return to its historic trend. Between 1952 and 2000, this ratio rose steadily-by about 1.5 percent annually-reflecting growing access to mortgages, consumer credit, student loans, and other forms of credit in the United States. After 2000, growth in household borrowing accelerated, and by 2008, growth in the ratio of household debt to income had climbed more than 30 percentage points above the trend line. By the second quarter of 2011, this ratio had fallen by 15 percentage points. At the current rate of deleveraging, it could return to trend by mid-2013.

 

In the wake of a highly destructive financial crisis, it is reasonable to ask whether a continuous upward trend in household borrowing is sustainable. A more conservative goal for US household deleveraging, then, might be to aim for a return to the ratio of debt relative to income of 2000, before the credit bubble. This would require a reduction of 22 percentage points from the ratio of mid-2011.

 

Another comparison is with Swedish households in the 1990s, which reduced household debt relative to income by 41 percentage points. By this measure, US households are a bit more than one-third of the way through deleveraging.

System "D":

 

A recent article at Foreign Policy noted that the $10 trillion global black market is now the world's fastest growing economy, and that in 2009, the OECD concluded that half the world's workers (almost 1.8 billion people) were employed in the shadow economy.

 

By 2020, the OECD predicts the shadow economy will employ two-thirds of the world's workers. This new economy even has a name: 'System D'.

 

According to an IMF economic study, black market, also called the shadow, underground, informal, or parallel economy, "includes not only illegal activities but also unreported income from the production of legal goods and services, either from monetary or barter transactions. Hence, the shadow economy comprises all economic activities that would generally be taxable were they reported to the tax authorities."

 

The IMF study also outlined the potentially serious consequences of the worlds fastest growing economy:

 

The growth of the shadow economy can set off a destructive cycle. Transactions in the shadow economy escape taxation, thus keeping tax revenues lower than they otherwise would be. If the tax base or tax compliance is eroded, governments may respond by raising tax rates-encouraging a further flight into the shadow economy that worsens the budget constraints on the public sector. (On the other hand, at least two-thirds of the income earned in the shadow economy is immediately spent on the official economy, resulting in a considerable positive stimulus effect on the official economy.)

 

A prospering shadow economy makes official statistics (on unemployment, official labor force, income, consumption) unreliable. Policies and programs that are framed on the basis of unreliable statistics may be inappropriate and self-defeating.

A growing shadow economy may provide strong incentives to attract domestic and foreign workers away from the official economy.

 

Based on an estimate by BusinessWeek, "Given US GDP of $14.26 trillion, the world's largest, that could still be as much as $1.2 trillion in taxable income that slips through Uncle Sam's fingers each year."

 

In fact, the shadow economy is part of the contributory factors to the current Euro crisis in the context of reduced government tax revenue and driving up consumer price levels. The IMF study showed in the 21 OECD countries in 1999-2001, Greece and Italy had the largest shadow economies, at 30% and 27% of GDP, respectively. In the middle group were the Scandinavian countries, and at the lower end were the United States and Austria, at 10% of GDP, and Switzerland, at 9%.

 

More importantly, the rise of System D highlights the inadequacy of global governments policies, processes, red tape, and bureaucracies. This infographic lays out everything about the black market, how it affects our economy and our culture.

http://www.businessdegree.net/black-market  

 

Strategy:

 

Many of you whippersnappers don't even remember the Beardstown Ladies.  They were grandmotherly-looking members of an investment club in Beardstown, Illinois who had generated 23% returns on the investment pool for many years.  According to a 1998 story in the Wall Street Journal:

 

The Beardstown Ladies are members of a famous investment club formed in the early 1980s. The ladies rose to prominence in the mid-1990s after the club proclaimed fantastic investment results. For 10-years ending 1993, the club reported a compounded return of 23.4% in their stock portfolio versus 14.9% for the S&P 500. The ladies bought stocks of companies they knew, like McDonald's and Coke. The investment success propelled the ladies into stardom. They appeared on TV shows and in commercials, spoke on radio programs, and not to miss a moneymaking opportunity, published bestselling books on the subject of personal finance and investing. The world changed for the Beardstown ladies in late 1997. A reporter from the Chicago magazine noticed something peculiar about their published investment results. After calculating the numbers several times, he concluded that a gross error had been made. The error was so large, that the accounting firm of Price Waterhouse was called in to clear the air. In the final tally, the clubs worst fears were realized. The ladies' actual return was only 9.1%, far below the 23.4% they reported, and well below the S&P 500. For years the ladies deposited monthly dues into their account and classified it as an investment gain, rather than additional capital. An embarrassed treasurer blamed the error on her misunderstanding of the computer software the club was using.

 

Unfortunately it's not just the Beardstown Ladies who can't do math.  No one questioned the returns initially because they wanted to believe it was true.  The exact same error is repeated by most 401k investors who often count their contributions as part of their performance.  Even in the absence of contributions, the rest of us favorably mis-remember our results anyway.  Psychology Today explains:

 

What was your portfolio return last calendar year? How did you perform relative to market indexes and other investors? Most investors don't know the answers to these questions. But their belief in their performance is quite flattering to themselves!

 

Two interesting studies illustrate this point. In the first study, William Goetzmann and Nadav Peles surveyed a group of investors belonging to the American Association of Individual Investors (AAII) and a group of architects about their retirement plan investment returns. The AAII investors are presumably very knowledgeable about investing from their participation in the association. When asked about their return the previous year, they overestimated their performance by 3.4% (= estimate - actual). Architects are very intelligent with a high degree of education, though they may not be knowledgeable investors. They overestimated their return by 8.6%. Both groups were also asked about their performance relative to a benchmark made up of the same asset allocation. The groups overestimated their relative performance by 5.1% and 4.2%, respectively.

 

Markus Glaser and Marin Weber also conclude that investors have biased views of their portfolio performance in the past. They surveyed individual investors from a German online brokerage firm and compared their self-assessments to their actual returns over four years. They reported a belief of an annual return mean of 14.9% over the period. Their actual return was more like 3.3%. Now that is overconfidence! In fact, there was no correlation between the actual return and the beliefs about the returns in the sample.

 

Cognitive dissonance strikes again.  According to Goetzmann and Peles in the Psychology Today article:

 

The authors attribute this to a psychological phenomenon called cognitive dissonance. The investors are mentally distressed by the conflict between a good self-image and empirical evidence of poor choices. To reduce the discomfort, investors adjust their memory about that evidence and those choices. This is then selectively re-enforced by noticing the returns of just their good performing stocks and mutual funds in the portfolio and not the poor ones.

 

Self-image wins every time.  A keen observer will note that investors never vastly underestimate their aggregate returns!

 

What can we learn from this, other than Germans are the most confident investors on the planet? The bottom line is that we all want to imagine we are getting or can get fantastic returns.

 

Right now we are smack in the middle of crazy season, where investors are examining their prior year returns and determining whether to stay with their current mutual fund or investment manager.  As an investment professional, one of the things you quickly realize is that you are being compared with imaginary numbers-what the client believes you should have done, or what they imagine they would have done!  Of course, as discussed above, the imaginary numbers are always terrific.

 

Cognitive dissonance, we believe, accounts for a lot of the manager turnover in the industry, not just volatility and style rotation.  As evidence, consider that according to DALBAR, the average holding period for mutual fund investors is about three years-whether they own a stock fund or a bond fund.  The volatility of the average bond fund is probably not enough to shake investors out, but when comparing the bond manager's actual returns with imaginary returns, investors can only handle three consecutive years of disappointment! This corresponds perfectly with studies of black-box trading systems, which indicate that investors who purchase even a profitable system abandon it after three consecutive losses.  (For fans of Markov probability chains, an average of only fourteen coin flips is required to get three heads in a row.)

 

When it comes to returns, we are all Beardstown Ladies at heart.  Our imagined returns are always going to be significantly higher than what we actually get.  Keep in mind that, according to the Psychology Today article, there was no correlation between the actual return and the beliefs about the returns.  Instead of being bamboozled by your inner Beardstown Lady, step back and really think about your investments.  Do they meet your needs?  Is the underlying return factor still sound?  Keep in mind that the only investment acumen required to actually earn the mutual fund NAV returns is to hold the fund!  You don't have to condemn yourself to DALBAR-type returns.  Sure, if something has gone really wrong, you might need to make a gradual change in course-but more often than not, if the return over a multi-year period is in the ballpark, you're quite possibly better off leaving it alone.  If you want to be a successful investor, you need to learn to deal with the real world and not imaginary returns.