Long Term Trends: Part 5: Consumer Debt

Here are some current trends:

1. Gas and Energy Prices remain expensive and may remain expensive in the future.
2. Food Prices remain high and may remain high in the future.
   
3. Consumer Income may not keep up.
   
4. People can no longer use their houses as ATM machines.
   

With consumers being squeezed, what will the consumer (the U.S. Consumer) do? Will they start saving more or will they continue to spend?

This will depend on many factors, such as culture.

In Japan, there is a greater inclination to save compared to Americans.

However, in the United States, the Savings Rates over the last decade is below 4%, a very low personal savings rate. Even during the recession of 2001, the savings rate remains low.

So Americans (and other cultures) still want to spend despite being squeezed by higher gas, energy, and food prices. This means that in order to continue spending, consumers will need to incur more consumer debt.

Ways to play this

Two obvious plays on increasing consumer debt include:

1. Mastercard (MA)
   
2. Visa (V)

Other plays include:

1. American Express (AXP)
   
2. Portfolio Recovery Associates (PRAA) - Engaged in purchase, collection, and management of portfolios of defaulted consumer receivables.
   

Credit Cards Used to Finance Healthcare Procedures

In the July 2008 edition of Consumer Reports, there is an article that details the increasing use of credit card to finance health care procedures. According to the article, $45 billion is spent today, and it could triple to $150 billion in 2015.

Beware of Rising Charge-Offs

Beware of Rising Charge-Offs. In the first quarter 2008, the Big Three all reported rising charge-offs. For example, the Bank of America charge-off rate increase from 4.73% to 5.19 percent.

Gold Chart Initial Price Target $1160

Inflation and Gold have been making the news. Recently, on CNBC's show Fast Money, Chartist Louise Yamada showed a chart of gold and made some analysis. Inspired by her work, we charted GLD, the Gold ETF. GLD appears to have a price 1/10 of the true price of gold. (If GLD is $98, then the price of gold is around $980 per ounce.)



In the chart above, we see a trading zone (triangle) from around $55 to $72. In the first leg, we see an increase from around $42 to $72, a gain of 71%. If we use this gain, and add it to the the trading zone base (near the end of the triangle), we get $116, or 71% above $68. This estimate matches what Louise Yamada mentioned on the air.

After this price target of $116, perhaps GLD will start consolidating, preparing itself for the next move (higher?)

Today's Chart of GLD

Effects of Falling Rates and Inflation on the Stock Market

In a previous article, we examined the historical Price to Earning Ratios of the US large cap index, the S&P 500.

Now, let us examine how a falling interest rate environment or low inflation situation affect stocks, stock performance, and sector performance.

Effect of Inflation on Stock Performance

Crestmont Research provides very interesting information on Inflation and Price to Earnings Ratios from 1900 to 2006.

When we look at Inflation (as measured by CPI) ranges, we see the average PE:

1. CPI Range (less than 0%): Average PE = 14
   
2. CPI Range (0 to 0.99%): Average PE = 16
   
3. CPI Range (1 to 1.99%): Average PE = 17
   
4. CPI Range (2 to 2.99%): Average PE = 22
   
5. CPI Range (3 to 3.99%): Average PE = 19
   
6. CPI Range (4 to 4.99%): Average PE = 16
   
7. CPI Range (5 to 5.99%): Average PE = 15
   
8. CPI Range (6 to 9.99%): Average PE = 13
   
9. CPI Range (10% or more): Average PE = 8
   

During times of low inflation, especially in the range of 2 to 2.99%, the US equity market supports a high PE ratio of 22. As we have deflation, or very high inflation, the average PE ratios are much less. The historic average PE ratio of the S&P 500 is 14 or 16 depending on how you calculate it.

In addition, the link above shows the general inverse relationship between inflation and stock prices. As inflation rises, stocks tend to fall. And as inflation drops from high levels (so long as there is no deflation), stocks tend to rise.

As of July 2007, the Inflation rate (through CPI) is 2.36%. Based on the chart above, this is a good inflation rate for Price to Earnings multiple expansion. As long as inflation remains contained, the outlook for US equities remains bright.

Effect of Falling Interest Rates on Stock Prices

The Fed, according to Fed Funds Futures, is likely to start cutting the Fed Funds Rate, currently at 5.25%.

How does a Falling interest rate environment affect stocks?

The Business Week magazine has an article showing the effect of falling rates and rising stock prices.

Since World War 2, the Fed has started rate cutting programs 10 times, and in the six month period after the first cut, the S&P 500 advanced by an average of 11%, two percentage points better than the average of 9% price increase in all years since 1945.

In the 12 months after the first rate cut, the S&P 500 gained an average of 18.6% and posted an increase in 9 out of 10 cases.

So for the most part, except for a few cases (such as the big drop in 2000-2002 due to excessive valuations of Nasdaq and S&P 500 stocks), falling interest rates are good for stocks.

Effect on Different Indices in a Falling Interest Rate Environment

Since 1945, during a falling interest rate environment, Growth and Blend methodologies in the S&P 500 returned 11%. Value stocks in the S&P 500 returned 7.9%. During a falling interest rate environment, large capitalization US growth stocks outperformed large capitalization US value stocks.

The small capitalization stocks as represented by the Russell 2000 or the S&P SmallCap 600 returned 7.8% six months after first interest rate decrease. However, this still underperforms the US Growth S&P 500 Index during a falling interest rate environment.

During a Falling Interest Rate Environment, it would be a good idea to invest in large cap growth stocks.


Effect on Sectors in a Falling Interest Rate Environment

Which sectors outperform and underperform during a falling interest rate environment?

According to Standard and Poors and the Business Week Article, these sectors performed in the six months after the first rate reduction (since 1945). The average percent change is listed:

1. Information Technology: +21%
   
2. Consumer Discretionary: +18%
   
3. Industrials: +17%
   
4. Consumer Staples: +14%
   
5. Energy: +12%
   
6. Health Care: +11%
   
7. Materials: +11%
   
8. Financials: +10%
   
9. Utilities: +7%
   
10. Telecom Services: +4%
    

During a Falling Interest Rate Environment, it would be a good idea to overweight Information Technology (Growth), Consumer Discretionary, and Industrials and underweight utilities and telecom services.


How I reallocated a portfolio to take advantage of the Falling Interest Rate Environment