Tuesday, February 5, 2008

A Cat Amongst the Mice

Most of my life I have been a dog owner; big lumbering hulks that could grab a loaf of bread off a table and never break stride or dig a trench in a birthday cake in the two seconds when a back turned. More recently a cat adopted us when he wandered in and found a bowl of mice in the kitchen. (Don’t ask, we live on a farm.) In any case, this is a different animal which calls for different attitudes.

One of the attributes of these sleeker more aloof creatures is the habit of regularly leaving a reminder that just because it was running away doesn’t mean he should have eaten it. For all the grace and apparent effortless meandering, there is often evidence all is not well, something like the economy at the moment? The current thrashing around with interest rates, stimulus packages, and political cliché, sounds like the precursor of a financial hairball. It can’t always be identified, but it’s always ugly.

The principal driver of the U.S. economy is the U.S. consumer. On average over twenty-five years before 2000, consumer spending accounted for around 67% of GDP. In recent years this has grown to 72%. This growth in the portion of GDP from consumer spending has come on the back of sub-par income growth driven by income extraction from equity (principally from home equity) and free and easy credit.

The previous equity bubble was caused by capital spending and deteriorating corporate balance sheets. Capital spending made up about 13% of GDP at the time of the uproar of seven years ago. What happens when the deflating bubble is six times as big?

What happens when unemployment increases and income falls, when the value of the house that acted as an ATM through home equity loans falls and when credit availability tightens? These factors are coming together. No doubt there will be solutions provided to keep the economic animal spirits of the country alive. But the cures won’t necessarily be painless. Likely the solution will be an attempt to expand another bubble, if the world cooperates. Our job as investors is to protect what we have and find the new opportunities.

Last week Countrywide sent out 122,000 letters to customers freezing credit lines because debt now exceeded property value. Chase lowered the borrowable percentage of home value from 90% to 70% in California, effectively closing the window. Even the apparent low rates on mortgage, below 5% are not clear, as “points” have been raised where none were before.

These are uncertain times for investors, and call for greater attention to preservation than the past several years. I am looking at more defensive investments for my clients and negative correlation to protect gains of the bull market through diversification and risk abatement.
When in doubt, zoom out. Look at the big picture. Every time I turn on another purported expert the recurrent theme is, “we just don’t know.” We don’t know the size of the problem; we don’t know the effect it will have on the consumer; we don’t know how many shoes are left to drop. Forget most of what you thought you learned about the stock market from 1981 to 2000 and don’t be afraid to try new tools but keep it simple.