Editor’s Note: Ken Safian has been providing detailed analysis of the markets and the economy for decades and his work provides an example of the application of the principles of technical analysis to economic data. This is a brief extract of a recent report that highlights this type of research and some background on the firm.
Flow of Funds – 3rd Quarter 2011
Since 2008 we have been referring to this economic period as a “new era”, yet investors and analysts do not seem to be revising their thinking and models sufficiently to reflect this situation. Undoubtedly, most have adjusted their way of viewing interest rate conditions due to Federal Reserve actions, but their measures of valuation, economic conditions and patterns of the consumer have not changed that much in the majority of cases. Certainly, the hedge fund industry has changed because of the difficulties and illegalities in this sector, but there is a long way to go before the authorities establish new regulations. Economic conditions in the world also have changed greatly. First, the major problems were in the U S in late 2008 when the economy imploded and the Federal Reserve opened up the financial system for the “sick” financial institutions and those others that may have caught the decease. After the rebound and sharp advance in 2009 and 2010, resulting in more bullish opinions, other difficulties started to develop. It seems everything, or most everything, the government did was short term in nature and the long term was unable to be dealt with. As these new problems arose, the “occupy” movement was developed, yet the program has really not focused on anything specific. While it provided an avenue to express frustration, it really did not change that much. Bearish attitudes are relatively high, but they are not high enough to conclude that the public is fed up and wants a change. In our opinion, the authorities are very fortunate that our population has been patient.
Certainly, the extensions of tax cuts and other assistance have kept the public more patient, but it surprises us that more demonstrations against the government have not risen. One reason for this may be that economic pain is not deep enough or it is focused in areas and not widespread. Similarly, there does not appear to be sufficient bearish attitudes given the degree of difficulties that seem to prevail in our nation. Possibly, most people believe the problems are abroad and mostly in Europe and not in the U S. It could be that since the Congress is so split and the public hears the different opinions by those on the left and right, there is not a necessity to make a lot of noise, demonstrate to a greater degree, and organize the movement.
Page 1 of our graphic section reflects the action of the public and its thinking. The decline of debt usage reflects a change in action and a corrective period, but the fact that unemployment rates differ within the country suggests more focused pain in certain states and areas than in others. Similarly, the cause of the problems now seem to be abroad more than it is here in the U.S. Given this introduction, we can now highlight some of the individual series presented in the graphic section. We suggest readers go over these graphs with text for important insights. The differences between the financial and nonfinancial sectors of our system vividly demonstrate some of the correction that has already occurred. Readers should focus on pages 31 and 32 which show the strength in the nonfinancial sector of corporate America. There is a large financial surplus in these corporations and financial ratios illustrate the record short term liquidity. It appears to us, however, that this will be a prolonged correction for our economy which may or may not result in a recession.
Conclusion and Highlights from Graphic Section
The first chart clearly illustrates the change in the use of credit in our system. The growth in credit has not contracted to this degree since the Flow of Funds data have been produced in its current form in 1952. However, GDP growth has been positive on a quarter to quarter basis due to the strength in other sectors than the financial sector.
The next chart illustrates the much smaller growth in nonfinancial federal government debt outstanding as a percentage of GDP in the private nonfinancial sector. Furthermore, please notice the much lower percentage of private nonfinancial debt outstanding as a percentage of total debt outstanding from a peak of about 62% in the mid 1970s to 46% most recently (charts 3 and 4).
In the fourth chart, shows financial debt outstanding rose dramatically faster than nonfinancial debt until 2007, which was one of the first signals that a slowdown in the economy was coming. Page 6 shows the relative slowdown in some forms of private debt in late 2003.
Editor’s Note: Due to space limitations, we have excerpted only a portion of the report and the analysis found on pages 7 through 30 of the original report has not been reproduced.
The last two charts present nonfinancial corporate data that have been very helpful in the past. One shows the surplus or financing gap between capital expenditures and cash flow. This series is quite favorable since it shows a large surplus. The final charts shown presents the favorable liquidity for nonfinancial corporations. This would suggest why high quality corporate bonds have a relatively low yield.
Total credit market debt outstanding as a percentage of GDP is much higher than the private nonfinancial segments since there is little production in financial products. Therefore, the growth in the financial sector is not totally reflected in GDP. However, when such a large spread develops between the financial and nonfinancial sectors, the government, investors, and bankers must be more cautious and adjust policies and regulations. This was not sufficiently done and the financial sector went to great excess and affected the total system. This was clearly reflected between the results of our Total Composite Forecasting Index and the Real CFI which excludes the financial segment.
Nonfinancial federal government debt rose sharply during the crisis period in 2008 and 2009. Such debt is still rising at double digit annual rates of gain due to Federal Reserve Policies. Prior to the recession period that debt was being relatively contained and then the bank crisis hit. As can be seen, total nonfinancial debt as a percentage of GDP rose sharply in 2008 – 2009. This debt as a percentage of all debt outstanding rose to a lesser degree, but the potential growth in the budget deficit suggests greater gains.
Private nonfinancial debt outstanding, which excludes government debt, was about $25 trillion at the beginning of 2008 and has been flat since its peak of $25 trillion in the third quarter of 2008. Private nonfinancial debt rose faster in the 1970s when inflation pressures were greater. Private nonfinancial debt to total debt outstanding fell from the early 1980s to date. Despite that lower growth, this debt as a percentage of GDP still rose from 100% of GDP in the mid 1970s to the mid 1980s to about 175% before the 2008-2009 recession. It should be appreciated that the growth in our system was mostly in the financial sector due to the leveraging of assets by businesses and individuals. Therefore, the growth in debt was centered in financial assets (see next page). The disparity within the stock market clearly illustrates better relative performance in nonfinancial stocks.
Why didn’t our nation’s leaders and the Federal Reserve emphasize the fact that financial debt was rising two times faster than nonfinancial debt in 2004? Thank you, Chairman Greenspan. This debt outstanding was down about 15% from a year ago in the fourth quarter, but it needs to be corrected due to the continued excesses in the financial sector. Please notice how this sector of financial debt has corrected more than government debt.
Nonfinancial debt as a percentage of total debt outstanding was flat recently, but fell from 62% in the mid 1970s to 46% recently. The financial and government debt outstanding was where the excess developed. Unfortunately, the Federal Reserve and other regulators did not attempt to slow this increased use of leverage, but corporate managements did not go to such excess in the nonfinancial segment. Just imagine if housing debt was contained.
As can be seen by this graph (as well as the earlier charts), growth in the GSEs as measured by this debt to GDP was substantial. This debt rose to almost 60% from 5% in 1979. This debt has slowed since 2004 and reflects correction in this segment.
These series have suggested stock market and economic peaks and troughs in the past. Please notice how current production cash flow for U.S. nonfinancial corporations declined sharply from early 2006 to early 2008. Capital expenditures at the same time continued to rise and turned down in 2008. This resulted in a large financing gap that required financing. The sharp drop in capital outlays in the recession along with the rebound in cash flow then resulted in a financing surplus. This, of course, provided the funds for increased capital expenditures which has occurred in most recent quarters. A large financing surplus now prevails. Investors should be aware, however, of the recession in corporate profits due to the Bureau of Economic Analysis revision of the profits which adjusted the earlier depreciation changes. We have discussed this situation in our earlier corporate profit studies. Overall, it seems that nonfinancial corporations are generally being conservative and, therefore, downside risk seems relatively
small.
As the economy deteriorated and then became more complex in financial sectors even though business conditions improved, nonfinancial corporations reduced the ratio of short term debt. As can be seen liquid assets to short term liabilities rose to levels in the early to mid 1950s. This reflected more conservative attitudes by nonfinancial corporate managers. In our judgment, this was the primary reason why some stock prices were able to reach new all time highs and more merger and acquisitions occurred. Generally this is a favorable factor and offsets some of the negative conditions in financial corporations.
Safian Investment Research, Inc., (SIR) and its predecessor firm, Smilen and Safian, Inc. have been providing institutional clients with uniquely creative and innovative investment research for almost half a century. It all began in 1961 with the publication of “The Dual Market Principle,” a monograph which divided the market into two distinct sector averages each consisting of either “growth” or “cyclical” equities, and which showed that a bull and bear market could exist simultaneously. The study was the introduction of modern “sector analysis,” which is now widely accepted. The recent environment has produced greater government influence on economic conditions. As a result, sector analysis has become an increasingly vital investment research tool. SIR believes that great transition is occurring in the world and that a new era is developing which requires a different approach to industry and economic analysis. SIR is confident that it has the experience and the record to produce the new thinking to provide such analysis.
Over the years, the firm has refined and expanded its studies and has developed many original economic series and approaches for both stock market and economic forecasting purposes. For example, in 1984 it introduced the Composite Forecasting Index (CFI), which successfully forecast each of the past three recessions of 1990-90, 2000-2001, and 2008. Those were the only recessions which were forecast. There were no false predictions.
Based on its research SIR produced a Recommended Equity Portfolio for Institutions Investors, starting in 1972, which significantly outperformed both the Dow Jones and the S&P 500 averages. SIR had managed money for many years and stopped managing money and issuing its recommended portfolio in August 2008. Clients’ assets are currently being managed by a former employee of Safian Investment Research.
LETTER FROM THE EDITOR
