Condition of the Consumer & Investor Challenges: Alpha Hedge West Conference

Next up in our series of notes from the Alpha Hedge West Conference is a panel called Condition of the Consumer & Challenges for the Investor as the Economy Expands.  It featured Joseph Brusuelas, Senior Economist at Bloomberg and Kristin Bentz, Executive Director at PMG Venture Group.

Condition of the Consumer & Investor Challenges 

"It is worse than you think"

Economic outlook is historically weak.  Economy is sluggish.  No escape velocity. Output gap of 6%.  For years pattern of unemployment rate similar to employment divided population.  Correlation broke down with recession.  

Low wage bias.  Student loan disbursement up a lot.  Q1 2003 roughly $250B, now almost $1T.  Student debt being used for study of subjects that don't pay much.  

Middle class disappearing.  People moving down to dollar stores from JCP, Sears, Walmart, etc.  Loss is real wages driving trend.  Trading down.  

Economy appears to be getting better, but really, the 1% is driving growth.  Recovery not broad based.  Wealth effect of Fed is benefiting top, but not trickling down.  

Spending has recently moved up in an unsustainable way.  "Layaway is back."  If deleveraging is over, the economy is going to come back.  Actually, deleveraging is coming from housing defaults.  Drivers of capital spending are autos and student debt.  

Lots of underbanked.  Amex & Walmart team up for underbanked ("Bluebird" product).  25% not banked.  Pawn shops thriving.  

Worldwide, US doing ok compared to Europe and Asia.  Asia is struggling.  Weak to poor outlook 12 to 18 months out.  

Yellen likely to replace Bernanke as the first female Fed Chief.  $140B tax hike at start of year.  Budget gap is closing now, but set to spread again in 2018.


Be sure to check out the rest of our summary of the Alpha Hedge West Conference.

U.S. Savings Rate Rises: Temporary or Trend Reversal?

We wanted to post up this chart courtesy of Paul Kedrosky which illustrates a 'black swan of U.S. savings.' As you can see at the bottom, the savings rate in America has been paltry. At best, it has steadily declined over the last 20 years. However, the massive recession we've seen has made people hunker down and we're seeing a return to shoring up personal balance sheets. Americans have tightened their spending so much that we've now seen the "largest three-year increase in savings in modern U.S. history" with the rate recently hitting 6.9%. This is obviously a good sign and hopefully can point to Americans changing their ways in the future. In a timely piece (we're biased of course), we just last week examined the highest yielding savings accounts out there at the moment. After all, numerous readers had been asking what to do with their large, idle cash positions. We considered all the emails and comments to be our own little subset of the current American mindset; a random sampling if you will.

While there are signs of improvement in consumer/saver behavior, there is still a distinction between a temporary adjustment and a permanent shift. You'll recall that Americans are programmed to spend, spend, spend. We are a consumer nation and we consume; it's what we do. So, we'll have to see an overall change in psyche for this positive recent trend to continue. Otherwise, it will become just another upward blip in the context of an overall downward trend. Because, remember, we have a serious problem when it comes to consumer balance sheets. Millions of consumers have massive amounts of debt and we've touched on the topic of downgrading the American consumer's credit rating in the past. It will be a long and arduous process to repair the damage. But, raising cash levels certainly helps. The problem is getting consumers to keep their savings rate high now that it is improving.

We postulated back in December of 2008 that the consumer savings rate would have to rise. It has. But, now what? We would now venture a guess that the vast majority of people are raising cash levels merely to stave off any uncertainty in the mean time. Then, once the 'good times' return again, they'll revert to their programmed ways. This is a reactionary move, rather than a proactive one. It is temporary. To truly get out of this mess and to solve one of the many enigmas of the crisis, consumers need to shore up balance sheets for good, not just 'for now.' How many Americans will truly change their ways? Unfortunately, that question will only be answered with time.

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Consumer Psychology In Recessions

Have to give a big hat tip to Value Plays for posting this up a while ago. Harvard Business School has a video out regarding consumer psychology during recessions. Watch the video below (RSS & Email readers will need to come to the blog to view it).



In the video, they discuss how both marketing and consumer behavior can be impacted by recessions and they bring up interesting points. In the past, we've highlighted that consumer spending during recessions is not quite what you'd think it would be.

Head over to Todd's site to check out his example of how Walmart has used the economic situation to refine their message while Target has suffered. Hedge fund manager Bill Ackman of course has confronted Target (read: gone activist), as he pushes for major changes in the company.

Consumer Deleveraging & December Retail Sales

We've mentioned many times before that the consumer has a rough 2009 ahead of them and that discretionary retailers could be in the house of pain. The following data simply backs up this thesis. We recently looked at consumer spending during recessions, and you might be slightly surprised at the findings. Courtesy of the NY Times, we see that retail sales in December were weak, especially at discretionary retailers.

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You'll also take note that Walmart (WMT) continues to be one of the lone bright spots in a dark consumer world. All along, we have advocated getting short discretionary retailers and going long the likes of Walmart (WMT) and McDonald's (MCD) as a hedge. The thesis here has always been that the consumer will trade down to cheaper alternatives and thus those companies will not suffer as much as normal, non discount retailers. And, after all, its merely a hedge to our overall bearish consumer bias.

Then, courtesy of the Big Picture, we see that consumer deleveraging has actually just really begun. As this trend continues, look for things to possibly get even worse in the retail world.

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As a result of the deleveraging, we've said that the consumer savings rate will have to rise. And, lastly, as the consumer struggles along, they'll turn to their credit cards to get by once they run out of cash. Thus, the credit card squeeze begins and companies with a lot of credit card/consumer debt exposure, like Capital One (COF), will continue to see a rise in delinquencies and charge-offs.

Consumer Spending During Recessions

Todd Sullivan over at Value Plays takes a quick look at consumer spending from the 1990-91 and 2001-02 recessions. Surprisingly, Tobacco spending was down. We only point this one because in recessionary times, people are quick to point out plays like Altria (MO) and Philip Morris International (PM). When, in reality, the spending in their product category is down. The increase in education spending has already played out again this recession, as the number of MBA program applicants has been very high, if not at historical highs. Lastly, we want to highlight the massive decrease in the category: food away from home. This illustrates perfectly our thesis for shorting casualty dining restaurants in a deteriorating consumer environment and going long McDonald's (MCD) as a hedge. Because, after all, if people do go out to eat, they are going to the cheapest place out there, the golden arches.

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Top 10 Worst Recessions

Blain over at StockTradingToGo has a nice post up comparing the longevity of past recessions to the one we find ourselves in currently.

1. 1929-1933, 43 months in duration (Great depression).
2. 1981-1982, 16 months in duration.
3. 1973-1975, 16 months in duration.
4. 1937-1938, 13 months in duration.
5. 1926-1927, 13 months in duration.
6. 2007-2008, 12 months in duration.*
7. 1970, 11 months in duration.
8. 1948-1949, 11 months in duration.
9. 1960-1961, 10 months in duration.
10. 1953-1954, 10 months in duration.

Now, the question ultimately becomes: how long does the current recession last? Well, for one thing, this recession only needs to last 4 more months to become the second longest recession. With the current auto bailout nonsense still going on, and no real relief for consumers coming anytime soon, we could easily see this recession moving up into 2nd place. We've got real issues to deal with here and these are certainly unprecedented times.

We recently wrote about how the consumer savings will have to rise in order for things to stabilize. Such a deteriorating consumer environment will definitely play a large part in the longevity of the current recession. The destruction of wealth that many "main street" Americans have and will experience should reach astounding levels and will impact many psychologically. An overleveraged American consumer was the backbone of the American for quite some time. But, times change.

See also Paul Kedrosky's recent Economic predictions, as well as a comparison between the current crisis, the Nordic crisis, and the Great Depression.

Consumer Savings Rate to Rise

The Economist has a great piece out about how the overleveraged American Consumer of recent memory is going to quietly take a backseat to the saving oriented consumer of decades past. Why? Well, because they will have to. The recession obviously has a negative impact on spending power and we've written numerous times about this current/upcoming phenomenon. Firstly, the decline in housing prices and the increase in the unemployment rate will obviously have a negative effect on the economy and in turn the consumer. Visa's consumer trends have already started to show this. Secondly, as these consumers find themselves struggling to get by, we'll notice that credit card debt will rise and we'll get a credit card squeeze. This, along with a ton of auto loan exposure has been the macro thesis behind shorting Capital One (COF). Add in the fact that they are continually seeing rising charge-offs and delinquencies and it's not a pretty picture. Lastly, add in the fact that many Americans have suffered from the destruction of wealth due to a horrible year in the stock markets.

All of the above plays right into our theme of shorting discretionary retailers and going long the "cheapest of the cheap" in consumer plays. The only retailers we want to be long in this environment are McDonald's (MCD) and Walmart (WMT). MCD makes sense because they provide cheap and easy food. When people are short on cash, that dollar menu goes a long way. WMT benefits from a similar thesis. When you're buying groceries, toiletries, you name it... Walmart has it and at the cheapest prices. Not to mention, they've got the Sam's club warehouse as well, playing right into our 'cheap' theme. As far as shorting discretionary retail goes, you can really take your pick. Whether it be casual dining chains, jewelry stores, or any leveraged consumer play, you have plenty of options. Or, you could just short the RTH retail index and then go long a select few retailers as a hedge. Consumers are/will be in a pinch for a few months to come and that's how you play it.

Now, take all the aforementioned facts and then add in this commentary from The Economist and you'll notice that a shift is coming. They write,

"On average, consumers from 1950 to 1985 saved 9% of their disposable income. That saving rate then steadily declined, to around zero earlier this year (see chart). At the same time, consumer and mortgage debts rose to 127% of disposable income, from 77% in 1990. Those forces have now reversed. The stockmarket has fallen to the levels of a decade ago. House values have fallen 18% since their peak in 2006. Banks and other lenders have tightened lending standards on all types of consumer loans. As a consequence, consumer spending fell at a 3.1% annual rate in the third quarter (in part because tax rebates boosted spending in the second), the steepest since the second quarter of 1980 when Jimmy Carter briefly imposed credit controls. More such declines are likely to follow. Richard Berner of Morgan Stanley projects that in the 12 months up to the second quarter of next year real consumer spending will fall by 1.6%—a post-war record. “The golden age of spending for the American consumer has ended and a new age of thrift likely has begun,” he says."

Lastly, take a look at this powerful chart. Personal savings has been in a steady downtrend ever since the '90s. Household debt, on the other hand, has almost doubled since the '90s. Something's got to give.

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Source: The Economist

Activision (ATVI): A Bright Light in the Dark Consumer World?

I am long a specialty retail play. I had to slap myself out of the stupor for owning one in an environment I have dubbed as a consumer recession. What am I long? Well, how about some Activision Blizzard (ATVI). I was fortunate/unfortunate enough (we'll know later) to get filled on some of my orders in the $10.xx region and I had a few more orders down in the $9.xx that did not get filled.

So, why am I long a retail name, much less a specialty retail name. Well, first and foremost, it is mainly as a hedge to some of my other retail shorts. So, let's make that abundantly clear. I am bearish on the consumer and the economy. But, such bearishness must be given protection to any rampant rallies that might occur and I've selected ATVI, as they are currently dominating competitors such as Electronic Arts (ERTS) and THQ (THQI).

Secondly, I would propose that video games are by no means recession resistant, but they are less affected by a recession than other types of specialty retail. Why? Gamers are hardcore. Many are addicts. A game costs a measly $40-60 bucks and gives you hours upon hours of entertainment. And, ATVI has some of the best titles out there right now, including the Guitar Hero franchise, Call of Duty (4th installment out for the holidays), World of Warcraft (new expansion pack out for the holidays), among many others. They offer relatively cheap products and this benefits them in an environment where the consumer is struggling. When that new game hits, most people gotta have it, especially if its an installment in an already proven franchise such as the games mentioned above.

Thirdly, in addition to the strong products set to hit for the holiday season, ATVI has some very highly anticipated games in the pipeline for the future as well. If anyone is a fan of Blizzard's games (now a part of Activision Blizzard), then you already know what I'm talking about: Diablo 3 and Starcraft 2. These are highly proven franchises and are long awaited sequels (especially Starcraft 2). The entire nation of Korea will probably pick up a copy of SC2, I'm not even kidding. The game's prequel, Starcraft, was that big of a hit over there. So, future revenue streams are well in place.

Fourthly, even in a weak consumer environment, ATVI was still able to deliver solid earnings and stick to their forecast. And, they even announced plans to buy-back $1 billion of stock. After all, they have $3 billion in cash. Some takeaways from the quarter,

"For the September quarter, Activision Blizzard had two of the top-10 titles in dollars on all console platforms in the U.S., according to The NPD Group. For the September quarter, Activision Blizzard had two of the top-five PC titles worldwide -- Blizzard Entertainment's World of Warcraft: Battle Chest(R) and Call of Duty 4: Modern Warfare, according to Charttrack, Gfk and The NPD Group."

And, some data from the recent quarter courtesy of Barron's Tech Trader Daily,

"For the quarter, the video game company posted non-GAAP revenue of $770 million, well ahead of the company’s previous forecast of $620 million. ATVI posted non-GAAP EPS of 7 cents a share, better than the company’s forecast of 4 cents. For Q4, the company sees non-GAAP revenue of $2.2 billion, with profits of 29 cents a share."

So, as you can see, the company is holding up fine so far in this environment. Yes, the consumer should theoretically weaken as we move forward, but ATVI has solid titles, is selling cheaper items, and is selling to a consumer who is not likely to give up their products, despite the recession. If you want any evidence that ATVI has a comparative advantage in titles, then simply compare ATVI's most recent quarter to rival THQ's quarter. Yea, that wasn't pretty.

Lastly, I want to highlight that $10 billion hedge fund Caxton Associates ran by Bruce Kovner was out adding ATVI as a new position in their portfolio last quarter. And, not only did they just 'add it,' they really loaded up. They brought it up all the way to their 3rd largest portfolio holding. I wrote about Caxton's purchase earlier, where I detailed their portfolio holdings. Caxton is one of the many hedge funds I track on Marketfolly.com.

ATVI is best of breed in the gaming space and I am happy to be long the name as a hedge to my other specialty retail shorts. (See my post on the deteriorating consumer environment for short ideas). But, more importantly, the company definitely has a bright near-term future with all the anxiously awaited titles they have lined up.

I would be remiss if I did not end this piece with a 'proceed with caution' label. Specialty retail is easily going to be the hardest hit in the retail space. This is simply going to be a case of "who loses the least." If you do not want to take on the risk involved with this name, I would highly suggest checking out cheap retail plays on the "trading down" of the consumer to cheaper alternatives. These names include the masters of the cheap domain: Walmart (WMT) and McDonalds (MCD). And, you can read my thoughts about MCD's dominance here. Apart from those, playing retail names from the long side will be a very uphill battle.

Credit Card Squeeze

I wanted to post up an excerpt from a piece in Fortune a while back which discussed the next Credit Crunch. In it, Geoff Colvin hints at what could be a difficult time for credit card companies. Some of this information sets up a broad backstory as to why one might short the likes of Capital One (COF), American Express (AXP), Discover Financial (DFS), or even banks like Citigroup (C) who have large credit card businesses.

Here's an excerpt from the article,

"Last year, just as the subprime crisis happened, credit card debt took off. The home-equity ATM had been shut down, so people turned to the last source of easy money they had left, the most expensive debt on the menu, credit card borrowing.

Since credit card debt has been growing much faster than the economy - more than 8% in last year's third and fourth quarters and over 7% in May (the most recent month reported)- people are apparently using it as a substitute for income. Thus, for the past year or so we have still maintained the standard-of-living illusion.

But a big crunch is coming - and here's why. Credit card debt, like mortgage debt, gets bundled, securitized, and sold off by banks. Citigroup (C), one of America's largest credit card lenders, just reported that it lost $176 million in the second quarter through securitizing such debt. That happens when the buyers of those securities observe rising delinquency rates and rising interest rates, and decide the debt is worth less than Citi thought. More generally, the amount of credit card debt that is securitized nationwide has plunged by more than half in the past five months because it's getting riskier. That means credit card issuers will be charging customers higher interest rates, and since the banks can't offload as much of the debt as before, they'll have less money to lend to cardholders.

The squeeze has already started, which is why Congress is in the process of passing the Credit Cardholders' Bill of Rights, which would prevent issuers from changing rates and terms without warning, among many other provisions. But bottom line, the credit card money window is going to start closing - and soon.

So now what? It's hard to see where consumers can turn next. Home prices seem highly unlikely to start rising again soon. Stocks? You never know, but the Great Bull Market looks like a once-in-a-lifetime event. Homes and stocks are households' biggest asset classes by far. There isn't much else to borrow against.

It may be that the standard-of-living bubble finally has to deflate. Sustainable increases in living standards have to be earned, not borrowed, and that means performing ever higher value work that can't be outsourced. We haven't been meeting that challenge very well; doing so will probably require much more and better education for millions of Americans, which takes time and money."

I agree with the overall theme of this article and truly believe that the strapped consumer is going to be facing larger headwinds than anyone anticipates (which I partly touched on here). Credit card debt is piling up for the average American, and many are having a very hard time paying it off. This simple concept was illustrated in a nice graph I posted earlier, showing how delinquencies are rising. Capital One (COF) is the perfect example of a company being impacted by this. It has been piling up each quarter and their most recent earnings/conference call gave us a further glimpse, as noted by Forbes' Melinda Peer, who writes

"Credit card and banking company Capital One (COF) said its net charge-off rate, or measure of soured loans, for its U.S. card business jumped to 6.34% in September, from 5.96% in August. Internationally, charge-offs rose to a rate of 5.87%, from 5.31%, in the same period.

Delinquencies, considered signs of troubled accounts, were also on the rise in the U.S. and abroad during September. Domestically the McLean, Va.-based company's 30-day delinquency rate inched up to 4.20%, from 4.07%, in August, and internationally the rate inched up to 5.24%, from 5.15%."

Calculated Risk also took the liberty of transcribing key comments from the conference call, which you can read here. Basically, the company is taking positive steps to reduce credit lines and try to limit their risk. But, they still won't be able to completely protect themselves from the impending tsunami.

Additionally, this WSJ article seems to imply that credit card companies and banks are going to face historic headwinds in the credit card arena. Overall, I truly believe this is going to be an over-arching theme that stems from the current crisis as things continue to bleed over to main street. The ultimate question becomes, how much of this is already priced into banking and credit card equities, if at all?


Full disclosure: At the time of publication, MarketFolly was short COF
Source: Fortune

Visa (V) Consumer Spending Trends

Earnings Breakout has some important highlights/takeaways from the most recent Visa (V) earnings report/conference call.

"-Debit is now 53% of payments
-All disputes with major competitors now resolved
-Further slowdown in U.S. (10%) and cross-border volumes. Debit low-to-mid double digits. Credit got weaker through September
-Additional moderation from September to October. U.S. credit volume +1-2% in September turned NEGATIVE first few weeks of October. Debit still low double-digits
-Seeing shift to non-discretionary purchases. More credit worthy are driving purchases
-53% of debit spend is non-discretionary. >40% overall. Last recession it was 30%"

Those last 2 bullet points re-affirm the fact that the consumer will be in a pinch for a while to come and consumer recessions can be brutal. That will of course drive down consumer spending and thus corporate profits, which in turn reduces earnings estimates. But, that's a no-brainer given that earnings estimates are too high to begin with. The trends that Visa is seeing are of course a result of a rising unemployment rate and sluggish housing market, among other things.

I like to use Visa (V) and Mastercard (MA) as gauges on the economy simply because they are purely payment processors. They process both debit and credit spending as more and more people are using less cash and more plastic to pay for their purchases. They essentially are our eye on the consumer. So, when the aggregators like MA and V notice big spending trends, you better pay attention. And, although the consumer recession is upon us and will likely worsen, I still like MA and V as much longer-term plays. Like I said, they are purely payment processors and the world is shifting away from cash. Legendary investor and former Tiger Management hedge fund manager Julian Robertson agrees and recently bought both MA and V. This investment will almost have to be treated as a value play given the fact that they will face near-term headwinds with the credit crunch and a consumer slowdown. But, long-term, I think these are solid businesses to own, and I detailed why here.

Check out the rest of the Visa (V) earnings/conference call summary at Earnings Breakout.

Death of the American Consumer

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Great image from the NY Post

Destruction of Wealth

Simply put, the destruction of wealth/income will have greater implications for this economy than many are anticipating. It is a ripple effect of this crisis that is barely even being accounted for.

Yes, we all already were paying attention to the fact that the unemployment rate is rising and that tons of jobs have been lost on Wall Street. But, what about those retail investors who invested in those financials and saw their shareholder equity wiped out? What about 401k investors who have seen their retirement savings and net worth decrease significantly?

This is a ripple effect of the pain coming to roost on Main Street. I'm not trying to be a harbinger of doom, but I don't think enough people are talking about it. The consumer is going to be in a much much deeper hole than many anticipate. Everyone has already factored in the job loss and tough economic times. But, in addition to the tough times stripping people of their jobs, you're now seeing Wall Street's woes put substantial pressure on people's savings (what little they may have). After all, we know that the savings rate in America is pitiful. The thin get stretched even thinner.

This Wall Street Journal article is the perfect example of that. Although this article deals with a woman who is already retired, the same principles apply. (The woman relies on dividends as a source of income). And, she is just one of millions who have been undoubtedly affected by the destruction of income and wealth.

People have lost their jobs; there goes their streaming income. 401k investors have lost 20% or more of their retirement savings; their retirement is now pushed back. Congress' budget analyst has estimated that as much as $2 trillion in retirement plans has been wiped out in the past 15 months. Retail investors with separate accounts have most likely also suffered notable losses; there goes some of their savings. So, where will they turn now? Certainly not to the home equity loans that were once so popular. The house ATM is all out of cash due to depreciating home prices. Need a loan? Oh I'm sorry you're already heavily in debt and we're tightening credit standards. Any and all of these situations in whatever degree of severity lead to a pinched consumer. And, a consumer recession is much stronger than any recession already being forecast.

People don't like to lose money. Period. Not only does this destruction of wealth put people in a bind, but it affects them psychologically as well. Consumer sentiment is already low, and it's about to get even lower.

But don't worry, we here at Market Folly believe eeeeeeverything will be just hunky-dory!!!
/sarcasm

Deteriorating Consumer Environment: Abercrombie and Fitch (ANF) Evidence

This is just continuing evidence of a lackluster consumer environment. Abercrombie and Fitch (ANF) same store receipts were down in August, setting up what I predict will be a downward accelerating consumer environment. Both Citi and Merrill Lynch downgraded ANF on Friday, citing deteriorating sales and increased markdowns. In fact, Citi went as far as to say that they think ANF could trade at its lowest multiple in 5 years. Just something to keep an eye on as you try to balance your portfolios.

Specialty retail is getting hit hard (and will continue to get hit hard) as effects from the housing market, consumer credit crunch, and inflation take a toll on consumer's pocketbooks. Abercrombie is known for its upscale niche within the teen segment, often selling more expensive items than the likes of competitors Aeropostale (ARO), who seems to be doing alright in this environment. So, look for consumers to "trade down" in this environment.

In any given sector, I like to take a balanced approach and often times am market neutral. For instance in retail, being long the likes of Walmart (WMT) or various other discounters who sell essentials (food, gas, toiletries, medicine) is very appealing to me. Then, you take the other side by going short discretionary retailers, such as ANF. Long cheap and/or necessary items; Short expensive and/or discretionary items. The same logic can be applied to food by going long the likes of McDonald's (MCD) for the "cheap" factor (although they might see some slight headwinds due to their strong international presence and a rising US dollar). Then, shorting casual dining restaurants such as BJ Restaurants (BJRI) or Darden Restaurants (DRI), who are feeling the pinch of rising input costs and slower dining traffic.

The main point to take away here is that we all know the consumer is strapped for cash. However, I think too many people are counting on a recovery. With vast evidence of the housing market accelerating to the downside, I just don't see how that is possible. Add in the consumer credit crunch and the inflationary pressures consumers are seeing on everything they buy, and you've got a recipe for a very thrifty consumer.

The Economy Sucks, the Housing Market Sucks, and the Consumer Sucks Too

Okay, I know the title seems pretty morbid. But, it's more realistic than you might want to believe. I want to point readers to a well-written piece that assembles some great data regarding the state of the American Economy. The article is aptly titled The Great Consumer Crash of 2009. It is written by James Quinn, a senior director of strategic planning at the Wharton School, University of Pennsylvania (one of the most respected business schools in the country). I originally tried to pick out select parts of the article to present to you here. But, after re-reading his work, I've decided that you simply have to read the entire article. Check it out: The Great Consumer Crash of 2009.

And, if you find the article remotely intriguing, I highly suggest checking out some of Quinn's other articles found on his author's page on the same site.