Thursday, April 17, 2008

Today's post from my favourite financial blogger Mike "Mish" Shedlock is long as usual but required reading for anyone seeking a clearer understanding of the mountains of information being throwing out at the newswires.


Consumer Spending Mirage

Amidst the frequently heard drumbeat of bottom calls, this more realistic headline caught my eye:
The Consumer Spending Mirage.

Stocks riding high on illusions of consumers continuing to spend may be in for a nasty surprise. Forecasting the stock market is a fool's game—but there are grounds to believe there's another drop in the market yet to come. The reason: a broad decline in consumer spending, which so far has been masked by a quirk in the government's statistics.

Combine that with a rapidly unraveling job market, high energy prices, and the continuing credit crunch, and you have the recipe for a drop in consumer stocks. A big decline there could take the rest of the market down with it. A closer look at the numbers shows that the consumer spending boom may already have come to an end, without investors noticing.

The problem is this: What the government calls "personal consumption" is actually a grab bag of items, some of which don't really fit the usual notion of consumer spending. For example, the nation's current annual personal consumption of $10 trillion includes about $1.8 trillion in outlays by Medicare, Medicaid, and private health insurance providers. This is real money, but consumers don't control or even see most of it, since it usually goes right to the health-care provider.

The government's count of personal consumption also includes "imputed" categories, that is, entries that don't involve any money changing hands. Two of the biggest examples: $1.1 trillion for "rent" that homeowners theoretically pay to themselves to live in their own homes, and $240 billion for "services furnished without payment by financial intermediaries"—in other words, the value of services like no-fee checking accounts.

In fact, once medical outlays and those two imputed categories are set aside, it turns out that the rest of personal spending has actually fallen since November, adjusted for inflation. The decline is pretty much across the board: inflation-adjusted purchases of food, clothing, furniture, and motor vehicles are all down.

Some economists think the combination of economic stimulus checks soon to arrive from the federal government and lower interest rates should keep consumer spending from falling off a cliff. "We think consumers will narrowly skirt a downturn despite the recession in the overall economy," write Richard Berner and David Greenlaw of Morgan Stanley (MS) in a just-released report.

But if the decline in consumer spending continues, it's going to be hard for the market not to follow. Like personal consumption expenditures, GDP also includes the government imputed value of "free" checking accounts and the value homeowners receive from renting their own house. Calculation of the latter is based on a survey of homeowners asking them what they would pay to rent their own house if they did not own it. This is as preposterous as counting the value of free sex one gets from one's lover as opposed to what one might have to pay visiting the local red light district. And pretending those "free" checking accounts have unrecorded value that consumers should be paying for is equally absurd. Banks sweep money out of checking accounts nightly, lend it out, and collect interest on it.

Hedonics are yet another mirage that never occurs. Computers are the best example of hedonics. Prices go down every year while processing power, disk space, and other features increase. Let's say you buy a computer for $500. The government tries to figure out what that computer would have cost last year. For the sake of argument let's say that number is $1,000. So the government records the sale at $1,000. Multiply this by every computer sold and you have a massive fictional number.

Hedonics also come into play with autos. For example, if the government decides there are new features or safety improvements on this year's models vs. last year's model, sales numbers are upwardly adjusted.Subtract out all of this nonsense and the US was likely in recession quite some time ago.

BusinessWeek has this correct: Consumer spending minus hedonics and imputations is lower than reported. One thing BusinessWeek did not mention is the massive increases in gasoline expenditures. The three month running total of gasoline purchases is 22% higher than a year ago. Wages are falling, unemployment is rising, and rising oil prices are cutting spending elsewhere.

Consumer spending, especially discretionary spending, has only one way to go and that is down. Psychology of Deflation Consumer Sentiment has soured. Most place the blame on falling home prices. However, such thinking is incorrect. Consumer sentiment did not sour because home prices fell. Home prices fell because sentiment soured. If that sounds wrong then think about it this way: "The pool of greater fools ran out". Once the pool of greater fools ran out, then and only then did home prices fall.

Interestingly, the pool of greater fools includes lenders. Countrywide Financial (CFC), Citigroup (C), Washington Mutual (WM), Wachovia (WB), and others were so arrogant that they thought they were immune from any crisis. They did not care if they sold homes to people who could not afford them. They thought rising prices would cushion them from losses. They thought wrong.

So who was the greater fool, the lender or the borrower? Walk-aways are going to show that lenders were as much the greater fools as borrowers. For more on this theme, please see

Walking Away: The Next Mortgage Crisis. Psychology has reversed for both consumers and lenders. Consumers no longer think they can sink $20,000 into a new kitchen and get any of it back. Instead of buying a new kitchen or an SUV, consumers are worried about the price of gasoline, eggs, cereal, milk, and produce as discussed in Energy Affecting Food Prices.

Lending standards have now tightened and banks are less willing to lend. Even those qualified to buy a home are having a difficult time in many instances.

In this case, cautious (even fearful) bankers are tightening credit. Why? Because it all started with cautious consumers refusing to play the greater fool's game with home prices. The attitude change by consumers caused an attitude change by banks. The attitude change by banks will cause a souring attitude in those who were still in denial and still willing to party. And so the cycle feeds on itself, and will continue to do so until it reaches an extreme in caution and fear.

Attitudes are like pendulums. Momentum carries both pendulums and attitudes to extremes. The pendulum of consumer recklessness has now reversed, having recently reached a secular peak. It will not stop at equilibrium on the way down. Instead, momentum will progress to a point of complete exhaustion marked by cautious saving instead of reckless spending.That process is now underway.

This secular reversal has a long, long way to go.

Mike "Mish" Shedlock

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