Dear Investors,

Five Things I Worry About

More than a few clients wonder if the stock market will inevitably head down a significant amount soon. Some even worry about a large crash like 2008. I’ve spent several newsletters talking about why I don’t think a large crash will happen and assuring everyone why I think things will be fine.

I want to explain a five of the statistics or indicators I regularly monitor and, more importantly, what they would have to show before I became concerned. I watch the federal deficit, private debt, financial sector growth, rail traffic and stock market valuation—but not hoping for the movement you may imagine.

After all, all investment advisors are in the business of selling their clients on investing, so I think it’s only fair to let you, the client, know what danger signs I look for and what might make me conclude that it’s time for us all to worry.

Federal Deficit

The Federal deficit is probably one of the most important and most misunderstood economic measures.

First, let’s get one thing out of the way: The deficit is neither good nor bad; it’s just a thing. It’s the mechanism by which net new financial assets (net new dollars) are added to the economy.

When an economy is in a recession, depressed, or stagnant, a growing or higher deficit is needed. The economy needs more dollars added to drive higher economic activity. When an economy is overheating and you have broad-based high inflation, a smaller or shrinking deficit is needed. The economy needs dollars to be taken away to slow down economic activity. The deficit does not need to be “balanced over an economic cycle” or any other such nonsense.

Right now, our economy is depressed. Very depressed. Unfortunately, the tag team of idiots (Republicans and Democrats) we have running the country has focused the past few years on reducing the deficit. As a result, the economy has remained stagnant. Continued deficit reduction runs the very real risk of creating a new recession. The chart below shows the size of the Federal deficit.
Business
You can see that since the stimulus was enacted in 2009 the deficit has been shrinking. It’s no surprise we saw the strongest economic growth around 2009 and 2010 with the stimulus and large deficit but mediocre growth as the deficit shrank.

The size of the deficit is also related to the next issue: private debt.

Private Debt

Unlike a government that never has to pay back the “debt” (I use quotation marks because it isn’t true debt) resulting from the currency it issues and introduces into the economy, households must pay back their debt.

If the government is not providing enough dollars into the economy via deficit spending, then households and corporations begin to turn to debt to keep the level of consumption in the economy high enough to support growth. As median wages for households have stagnated and the government has pulled spending from the economy, the private sector has increased its loans from financial institutions to make up the difference. This has taken the form largely of real estate-related debt but also includes other forms, such as credit cards, student loans, and so forth.

The chart below shows how increased levels of household debt corresponded with stagnant wages and how household debt skyrocketed under Clinton’s nonsensical balanced budget push.

As you can see, we still have a long way to go before private sector debt levels return to a level I would view as reasonable and prudent. I’m also keeping my eye out for any sustained upturn in private debt levels that could signal another debt bubble.

Why is private debt so dangerous? Well, that leads in to the next item I monitor.

Financial Sector Growth

Private debt is a temporary solution. When the government creates a dollar and adds it to the economy via deficit spending, that dollar can stay in the economy forever. The government never needs to pay it back. They just continue to roll the debt over so the money stays in the economy. Here is a chart from a previous newsletter showing how our national debt gets paid off COMPLETELY and reissued almost 5 to 6 times per year.

But, you, dear reader, are different. Every person has a finite life and our lending institutions want their money back before we die. This leads to a problem. Taking on debt can sustain growth in the short term, as we saw during the Clinton and early Bush years, but eventually households can bear no more debt and the Ponzi-like scheme collapses.

Let’s say you take out a car loan to buy a new $30,000 car. You stimulate the economy by purchasing the new car now. Then, over the next five years, you pay back the loan and because you are charged interest you end up paying $33,000. (I’m just making up number here.) You now have a $30,000 car (bear with me, I know it’s technically worth less due to depreciation) for which you paid $33,000. The $3,000 difference went into the hands of the bank. You are now $3,000 poorer, but the bank is $3,000 richer because it has your $3,000 as profit. If you had paid cash for that car (and not paid the bank that extra $3,000 in interest), then you may have spent that $3,000 by going to the movies, eating out, buying a new TV, and so forth. So that $3,000 paid in interest is not stimulating the economy but is instead going into the hands of the bank where it ends up stockpiled in the hands of bank executives with a little trickling down to shareholders.
Now, multiply that example over hundreds of millions of people and billions and trillions of loans and we have a serious issue.

The larger the financial sector grows, the more money it siphons from the real economy. Thus, one of the things I keep my eye on is the size of the financial sector and what its current “hot” areas are. Banks and other financial groups have been buying up blocks of homes and rental properties.

Below is a chart from a Harvard study on housing affordability.


(Source: http://www.jchs.harvard.edu/sites/jchs.harvard.edu/files/ahr2013_05-affordability.pdf)

As you can, see rental rates (orange line) have been growing while renter incomes (purple) have been shrinking. The more money the financial sector sucks from renters, the less money there is to keep the economy growing. For every extra $100 a family has to pay to  BlackRock, Inc. (NYSE:BLK) (a large financial institution), that’s $100 less the family is spending out in the real economy and $100 less economic activity for us all.

Rail Traffic

The United States is a big country, and the

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