A Penny Saved

I want to talk about saving, but first, another swipe at Hank.

Now, Paulson says we need a stronger regulator for Fannie and Freddie. (Translation: “Give me a blank check to hand over to Fannie and Freddie, THEN we’ll start overseeing them.”) His comment on the matter:

“We have long maintained that the GSEs have the potential to pose a systemic risk and worked with Congress on legislation to create a GSE regulator with authorities appropriate to the task and on a par with other financial regulators.”

Oh, really?

I must’ve missed that bill from long ago. Oh wait – you mean the recent discussions, as in just within the past week or so?

If Hank has “long maintained that the GSEs have the potential to pose a systemic risk,” he’s derelict in his duty in not having done a darn thing about it. I’m surprised no one’s calling for his head. Personally, I'm sick of seeing his name on the currency in my pocket. From now on when I go to the bank to make a withdrawal and they ask, "How do you want that?" I'm going to say "Nothing larger than a twenty, and nothing with Hank Paulson's signature on it.

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Now, on to the topic at hand. Yesterday I pointed out that the failure of Fannie and Freddie might be a good thing in that it would usher in greater financial responsibility on the part of not only lenders, but households as well. A recent Bloomberg story agrees:

“The US housing crisis may accomplish what years of parental hectoring couldn’t: Turn Americans from spenders into savers. Spending will fall because homeowners can no longer use rising real estate values to borrow cash - $837.5 billion in 2006 … (and) with mortgage lenders requiring down payments of 20%, the average household, which puts away less than 1% of after-tax pay, will have to save 10% for ten years to buy a home.”

And that’s a very, very, very good thing.

You see, savings – not spending – is the engine of economic growth, in spite of the kool-aid that’s been flowing from Washington and Wall Street since – well, since Alan Greenspan (aka “Mr. Bubble”) became Fed Chair.

For evidence, look at two things: recent economic growth in China, India and the US along with their respective savings rates, and long-term patterns of stock market appreciation, along with the savings rate, in US history.

Regarding the former, China – and until recently, India – have been posting double-digit output growth rates for several years now, and both countries enjoy double-digit savings rates as well. All that savings provides the capital that is the true engine of growth. In the US, where the savings rate has been near nil for years, the economy is built on a mountain of debt, which produces sustainable growth averaging below 5%, and with the always-looming threat of the house of cards collapsing, which is beginning to happen.

As for the latter, examining long-term stock market behavior follows Kondratieff Wave Theory, for those familiar with it, which is a study of long-term cycles.

If we look at the stock market over its history, it tends to move in long-term (15 years or so) cycles, either up or sideways. The cycles are driven by different factors, but share some commonalities: they begin with a sustainable, reasonable pace of appreciation, then begin to become increasingly speculative, with historically above-norm, unsustainable returns, almost always culminating with a bubble, which then bursts, and the sideways trend begins.

During the sideways cycles, sure, there are ups and downs - opportunities to make and lose money, if you’re a market timer. But from beginning to end, there’s little to no appreciation in the market during those cycles. And market timers tend to lose money more often than make it.

Back in 2001 I looked at the S&P 500 from 1930 to present, and observed the following cycles. (For the record, at that time I predicted, based on this cyclical behavior, that stocks would trade sideways for about 12-15 years, beginning from March 2000 when the dot-com bubble burst.)

The first, from 1930 to 1946, was a flat cycle (let's call it F1). Then, from 1947 to 1966, we had an up cycle (U1). Then, from 1966 to 1982, another flat cycle (F2). Then, from 1982 to 2000, another up cycle (U2). And now, from 2000 to present, another flat cycle is in its second half (F3). We’ll examine each of these in turn.

F1 was brought on by the Depression, and it was only World War II that ultimately pulled us out - not the New Deal, which failed. (Wry side note: the creation of Fannie Mae and Freddie Mac was part of the New Deal.) The S&P 500 began and ended this period at about 15.

U1 resulted largely from the post-war industrialization and innovation, as well as population demographics. The first six years were marked by steady, sustainable growth in the S&P of about 10% a year. The next eight years brought returns of about 25% a year, and the increased volatility one would expect with such speculative returns.

That occurs because increasing numbers of untrained speculators enter the market (think day traders more recently; back then it was everybody and his brother becoming a stockbroker), and they kid themselves into believing that “things are different this time” (remember how technology was supposed to have killed the business cycle as we know it, during the dot-com bubble? or how home prices were supposed to go up forever?).

But there are occasional big sell-offs when the smart money sees that things are overdone, which results in higher volatility. After that eight-year stretch of 25% returns, we got a 23% correction in six months in early 1962, then a 69% gain in 3.5 years - fueled by strong, but ultimately unsustainable growth in profit margins, a bubble that formed because people thought those margins were sustainable long-term, and used them in their valuation calculations.

F2 then began a 16.5-year period of sideways but volatile trading, with the S&P rising, beginning to end, just 12 points or so, for an average annual return of about 1% during a time when bank CDs averaged almost 8%. The primary culprits were fiscal policy blunders, oil shocks, and hyperinflation.

U2 kicked in around mid-1982. The baby boomers and the tech revolution helped drive average annual returns of about 20% a year for the first 12 or so years (even that is historically above the norm), also aided by the expansion of credit through securitization. There were major corrections in ‘87 and ‘90.

Then, the dot-com bubble kicked in, along with Alan “Mr. Bubble” Greenspan’s easy-money policies, and we had returns of about 40% a year from 1995 through 2000.

There was a 19% correction in six weeks in late 1998. During the second quarter of that year, based on the indicators I follow, I started predicting a recession, and economic performance headed that way. But the Fed threw me a monkey wrench when Greenspan cut Fed funds 75 basis points in six weeks due to the Long-Term Capital Management hedge fund melt-down - a previously unthinkable government bailout of bad investment decisions (that has since been repeated by Mr. Bubble’s successor, Helicopter Ben, and his pal Paulson). So the rally continued, with increased volatility, until the 2000 bursting of the bubble.

The initial driver behind the current sideways trend, which has seen the S&P fall from about 1500 in mid-2000 to about 1250 now, was the bursting of the dot-com bubble and the resulting recession. We climbed out of that on the back of more easy money - a Fed funds target kept too low too long - and financial chicanery on Wall Street that enabled widespread lending “innovation” (an aside: wasn't the SEC supposed to have tightened things up in the wake of the dot-com bubble's corporate and accounting fraud? weren't the ratings agencies supposed to have improved their game? and calling subprime lending “financial innovation” is like calling the development of ricin “chemical innovation”).

But a housing bubble can't produce real, strong, sustainable economic growth - look at most economic indicators, and by the housing peak in 2005-06, we hadn’t gotten nearly as strong as we were before the last recession.

So what, you ask, does all this have to do with the topic of today's post - namely, saving?

One commonality of all the up cycles discussed above is the savings rate, which began each up cycle around 8-10%, and dissipated as the cycle ran its course. At the beginning of U1, it was high because of the Depression and the war, both of which encouraged thrift. At the beginning of U2, it was high due to the previous decade’s hyperinflation.

Now, it’s been all but eradicated by broader stock market participation (I actually heard a fellow CFA charterholder say, in 1998 or so, “Why should I put money in a savings account at 3% when I can buy stock mutual funds and get 30%?”) and easy credit with no money down.

Tightening of home equity lending standards (I’m all for banning them altogether, along with 401k loans), requiring higher down payments on all kinds of loans, reducing credit card lines, returning to verified income and using debt-to-income ratios instead of FICO scores as the basis for lending, shortening auto financing terms – all of these things may come to pass as part of the fallout from the housing bubble and subsequent credit crisis.

And that’s a good thing, a thing that could end the sideways trend we’re in now, if the result is an increase in the savings rate to about 8-10%. But history – and what we know today about how long it’ll take for the fixes to work through the system – tell us that’s a few years off yet. The workout of the housing bubble and the global credit crisis, which is far from over, won't come until late 2009 or perhaps 2010 to 2012. That means the sideways trend we're in today will persist until several years beyond that - say, 2012 to 2015 at least.