Monday, February 23, 2009

The Spring of ‘97

The Lehmann Letter ®

Today the stock market fell back to its spring 1997 level.

It would be bad enough if we had suffered stagnation over the past 12 years, so that the market did not have far to fall. But that’s not the case. We’ve had two booms in the intervening years: The dot-com bubble of the late 1990s and the housing bubble of 2003-2007. In both cases the stock market and the economy surged to robust levels before tumbling back down. The tech boom ignited the first boom. What generated the second (housing) surge and collapse?

We know about the Federal Reserve’s easy money policy and the marketing of sub-prime mortgages. To get the big picture, however, it’s useful to think of the nation’s balance sheet: Assets on the left and debt together with net worth on the right. All of us would like to build the left side – cash, investments, cars, homes – with as little debt as possible on the right side. That didn’t happen. We piled up the cars and homes on the left side by financing their acquisition with growing debt on the right side.

That, of course, meant that the ratio of net worth (assets minus liabilities) to debt fell as the mountain of homes and cars grew – financed by debt (liabilities). When financial analysts examine balance sheets they conduct a variety of tests to determined their health. One test examines the ratio of cash or cash equivalents (bank accounts, U.S. Treasury securities) to debt. As our debts grew faster than our cash, we failed that test. But it wasn’t clear that we were failing the other test: The ratio of net worth to debt.

That’s because asset inflation boosted the value of our stock-market portfolio and our home’s values without adding to our debt. That built our net worth (assets minus liabilities). This offset the effect of rising debt employed to acquire cars and homes. In a nutshell the two ratios – cash to debt and net worth to debt – did not cause alarm despite the deterioration of the first. Net worth to debt remained strong because the asset inflation of stocks and homes also buoyed net worth.

So there we were: Surging assets and surging debt, with net worth surging, too. What went wrong? The downfall began when the housing bubble burst and gathered speed when the erosion of home values began to pull down stocks. As home values and stock-market values withered, so did net worth. But debt remained. So now the ratios – cash to debt and net worth to debt – shrank, and we became bad prospects for additional loans. Lenders don’t like to provide additional credit to folks with bad balance-sheet ratios.

Problem was, our borrowing supported the spending that had grown the economy. Less borrowing and spending led to recession. As employment opportunities withered, our willingness to take on more debt – in order to support more spending – also withered. We became concerned with our balance-sheet ratios and wanted more cash and less debt. But shunning debt and cutting spending made the recession worse.

So now we’re locked in a downward spiral of debt and expenditure reduction, trying desperately to reorient our cash-debt and net worth-debt ratios. Who will borrow and spend?

That’s where Uncle Sam comes in. Or economy has grown to depend upon borrowing to support its spending. As private borrowing and spending recedes, public borrowing and spending must take its place.

Question is: Will it be enough as households adjourn to the sidelines and mend their balance-sheet ratios?

© 2009 Michael B. Lehmann

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