I just finished reading The Age of Deleveraging by A. Gary Shilling and I agree with his analysis and conclusions. I think that his book is the most important book on economics that I have read this year so I included some notes from the book for my future reference. Part of the reason I enthusiastically agree with his analysis is because it matches my own analysis. Over several posts I have been looking for signs that the consumer is actually deleveraging. Part of my curiosity stems from listening to Dave Ramsey try to convince people of the benefits of becoming debt free and wondering whether he is part of a larger trend. The other part is trying to figure out what the average American will do with their investments and disposable income in a slow growth environment. Mr. Shilling and I come up with the same conclusion. It is time for the American households to unwind the excess borrowing on credit cards and student loans that occurred over the last thirty years. Consumer spending as a driver for the economic growth is tapped out.
In a similar way I was fascinated with the problems that CALPERS and other pension plans are facing if our economy fails to grow at 4% per year. It seems many of the pensions plans are making big bets that the economy will grow at 4% and the stock market returns will grow much faster than that. The reality is that CALPERS recently announced that their 1-year return was 1%, their 10-year return was 5.7%, and they are spending about 6.4% of their portfolio on benefits. For kicks I charted the inflation adjusted returns for the GDP(blue line), S&P 500(red line), and our total debt(green line). From the chart you can see a pretty good correlation between the three indices from 1980 until 2000. For that time period I came to the conclusion that the growth in debt from was primarily responsible for the growth in the economy and the stock market. Traditional economic theory seems to be working. After 2000 the correlation falls apart. It is as if we passed a tipping point and the equation we use to describe the economy changed. Increased debt was no longer a good thing for the economy or the stock market. Debt soared but the economy hardly budged off of its long term trend line and stock prices went down on an inflation adjusted basis. For pension plans like CALPERS that really sucks! For those who think we can borrow our way to economic growth, you need a new plan. I was pleasantly surprised the Mr. Shilling noticed the same problem with inflation adjusted stock returns and debt.
Here are my cliff notes from the book and two posts about the book at BusinessInsider.
Slow Growth Ahead
Global slow growth in the next decade will result from the U. S. consumer retrenchment, financial deleveraging, increased government regulation and involvement in major economies, low commodity prices and the shift by advanced lands to fiscal restraint.
No Help from Anywhere
Four more reasons for slow global growth: Rising protectionism, continuing U. S. housing weakness, deflation and weak state and local government spending.
Chronic Worldwide Deflation
Deflation comes in several varieties, but is fundamentally driven by supply exceeding demand. Productivity-saturated new tech and globalization will drive the good deflation of excess supply while slow economic growth introduces the bad deflation of deficient demand. As the combine, I look for chronic price declines of 2 to 3 percent annually.
Twelve Investments to Sell or Avoid
#1 Big-ticket consumer purchases
Consumer discretionary spending is getting whacked as Americans grow debt shy. Moreover, consumers will have less money to spend.
Autos, appliances, airlines, cruise lines and leisure and hospitality providers will suffer.
#2 Consumer lenders
America could be finally, finally kicking the credit habit. Credit card companies, like Visa (V), and various financial firms will pay the price.
#3 Conventional home builders
Home prices are dropping (Shilling predicts a 20% drop). People are losing interest in giant McMansions. Add to that America’s newfound antipathy toward debt and you’ve got a bear market for home builders.
You might want to avoid PulteGroup (PHM), Beazer Homes (BZH), M/I Homes (MHO), Ryland Group (RYL) and KB Home (KBH).
Collectibles are another casualty of deflation. That Rembrandt could be worth less in a few years.
Home prices aren’t done crashing. When they do, banks will suffer from a wave of foreclosures. The financial system will be revived after the crisis with new profit-crushing regulations.
Mortgage heavyweight Bank of America faces the biggest liability.
Shilling also names Goldman Sachs as a potential target for CDO suits.
#6 Junk securities
Shilling calls this year’s rally in junk bonds overblown. Slow revenue and cash flow growth will make it impossible for many firms to service debts.
#7 Flailing companies
Companies with below-average revenue growth and high fixed costs and debt will be the first to drop in the coming era.
Shilling does not give any examples. We’re going with US Steel.
#8 Low tech equipment producers
US industrial production has stalled and won’t need many machine tools and parts. Besides, these products are made a lot cheaper abroad.
#9 Commercial real estate
Demand isn’t increasing as the US economy stalls. Moreover, loans made in the bubble come due in 2012, threatening a wave of foreclosures that will crater demand.
Slow global growth means there won’t be much supply pressure for oil and other commodities. Meanwhile, deflation will bring down prices.
#11 Chinese and other developing country stock and bonds
Emerging markets aren’t there yet, Shilling says, and won’t be able to pick up the slack from a languishing U.S. For overheating markets like China, this will lead to a sudden crash.
#12 Japanese securities
Shilling predicted the Japanese crash in 1988, and he says the slow-motion train wreck isn’t over yet. Bad demographics and lack of export growth are just now making their pretense felt.
Ten Investments to Buy
#1 Treasury bonds
Shilling says he has been a 30-year Treasury bull since 1981. The "bond rally of a lifetime" is going to continue as deleveraging causes deflation. Even Ben Bernanke won’t be able to stop that.
#2 Dividend payers
There won’t be much growth, so you might as well collect dividends. A few examples include Procter and Gamble (PG), Unilever (UN), Coca Cola (KO) and PepsiCo (PEP).
#3 Consumer staples
Consumer discretionary spending is getting whacked, but people still need to buy bread and socks. Stores like Walmart are well-positioned to grow.
#4 Small luxuries
People want to spend money on something. Shilling says items like snakeskin tote bags, five-blade razors and designer jeans could be the new type of conspicuous consumption, taking the place of big ticket items like sports cars.
#5 The dollar
With Europe and Japan drowning in debt and emerging markets verging on a crash, the dollar is going to start looking pretty good. Shilling says the dollar will remain the world’s currency, with no real competition from gold or the yuan.
Meanwhile, America will be mired in deflation.
#6 Investment managers and financial planners
Low investment returns will discourage day-traders and encourage the use of professionals.
#7 Factory-built houses and rental apartments
Cheap small homes are the order of the day, as old people look for a cheap retirement spot and young people look for a small mortgage.
Renting will be a more and more popular strategy.
#8 Health care companies
As America ages, the health care industry seems unstoppable. Even Obama’s health care reform ended up boosting earnings for many companies.
#9 Productivity enhancers
Anything that helps juice bottom lines will do well in the new era. This includes consulting groups, computers, internet, biotech and telecom.
#10 North American energy
Shilling is bullish on deepwater drilling and natural gas, as well as coal and nuclear. He has particularly high hopes for the massive Canadian oil sands.