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Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20…

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Fractured Fair Retails

In recent discussions we've highlighted the fact that for the average US consumer, the cost of living is clearly rising. Without question, we know the Fed has been hell bent on "reflating" the US economy. In the globalized financial markets of today, Federal Reserve actions no longer primarily influence the US alone, but rather have consequences across worldwide asset markets. Certainly a part of the Fed's focus on reflating the US economy has been to overtly debase the US dollar via unprecedented money printing. And if dollar debasement is a proper measure of Fed monetary policy success, then they've hit it out of the park with this one as the dollar has recently been flirting with all time lows. That might be great for US export driven companies, and has been as per their earnings growth, but for the average US consumer so far US Federal Reserve policy has driven up the cost of household energy and food necessities while wage growth stateside has languished.

As chronicled in a prior discussion, as we look back over the last four decades, every time energy and food prices have accelerated, the year over year change in US wages has been accelerating. There are only two exceptions to this experience - 2008 and now. In a world where the cost of living to households is growing and yet wage growth is not following along to fill the cost versus income gap, households are faced with two choices, either draw down savings to meet heightened expenditures or change consumption patterns. If one measures US savings from the spike high peak in early 2009, we can say there has been some diminution in savings. But as you'll see n the chart below, it's a bit of a weak argument.

US Savings Rate

Yet concurrently, we have not yet seen a dramatic shift in US consumption patterns as we look at retail sales. First, we all need to remember that gasoline sales are included in headline US retail sales numbers. So the "problem" that is higher energy costs to consumers actually shows up as a positive in headline retail sales growth. As always, we simply need to be aware of what we are looking at with headline economic stats. But there is yet another important issue for US consumption patterns both in terms of what has already occurred up to this point in the current cycle and what will occur ahead. And that issue is disposable personal income (DPI). DPI is personal income less taxes. It's what's left over after taxes for the average consumer.

The fact is that from year end 2007 to year end 2010, US disposable personal income grew by $895.5 billion, or 8.4%. That's 2.8% annually. Hey, that's not too bad amidst the greatest recession since the depression, right? It's no wonder consumers have been able to handle the higher cost of energy and food without even breaking stride, no? But wait a minute, hasn't wage growth been stagnant? If so, just where has this growth in disposable personal income come from? Herein lies the issue of importance that is very much deserving of attention as we move into the back half of the year.

In looking "underneath the hood" of the Government's calculation of personal income, we find it broken into a series of categories - wages (the largest by far), interest income, proprietors income (think small businesses), rental income and government transfer payments. From the fourth quarter of 2007, US wage and salary income is actually down through the end of last year. Not too hard to understand given US labor market difficulties. Rental income is up; accelerating meaningfully over the recent past as continuing foreclosures have tightened rental vacancy rates and pressured rental costs higher. The increase in rental income accounts for about 15% of the total growth in personal income. Next, it should be no surprise to anyone that personal interest income has declined over the 2008-present period. The Fed "medicating" the US Treasury market by keeping interest rates at generational lows is the driver of this phenomenon. Retiree's living on fixed incomes are simply overjoyed, no? Lastly, it should be no surprise to anyone that given the very somber outlook of small businesses over the entire economic recovery cycle to date, proprietors income from year end 2007 through year end 2010 is down very modestly. So wait one minute, personal wages, interest income and proprietor's income are all down in nominal dollar terms since the fourth quarter of 2007 and rental income is up only about $140 billion. And yet disposable personal income is up $895.5 billion? Just how do we make the simple math work here?

First, remember that disposable income is after tax personal income, so we need to bring taxes into the equation. Secondly, the glaring omission in the paragraph above looking at the components of personal income was government transfer payments. From the fourth quarter of 2007, government transfer payments to individuals have increased by approximately $540 billion. Additionally, government tax receipts from individuals since 4Q 2007 have declined by $217 billion. Bottom line being, of the $895.5 billion increase in US disposable (after-tax) personal income since year end 2007, just shy of $760 billion is made up of an increase in government transfer payments and a reduction in government personal tax receipts. You already know this was entirely funded with increases in US national debt.

Government Transfer Payments

So the key here is that since year end 2007, 85% of the increase in US disposable personal income has been driven by some sort of Government stimulus. And of course the key question looking ahead is whether or not this is sustainable?

On the personal tax side of the equation, we have witnessed many an iteration over the past few years. From checks being sent to SSI recipients, to tax credits for car, home and appliance purchases, to the most recent incarnation that is the 2% payroll tax decrease for individuals set to sunset at year end, it has been one tax stimulus program after another all financed with increased US Federal debt. But from a longer term standpoint there is simply no way this will continue. Why? It seems self obvious as per the chart below.

Personal Tax Receipts

The ever insightful folks at S&P putting US Federal debt on negative credit watch a week back simply highlights the anomaly you see above. Add in State and local muni fiscal issues in addition to what will be the Federal Government explosion in Medicare costs in the years ahead and all we can say is individuals better enjoy these tax rates while they can as they are clearly unsustainable to the downside. Federal, State and local muni governments ahead will have no choice except to raise taxes AND scale back services in order to right their fiscal ships.

In terms of direct government transfer payments, increased unemployment benefits account for about 20% of the total transfer payment numbers detailed above. Of course transfer payments include ongoing promised obligations made to the elderly and the poor which will not be going away anytime soon, but certainly are part of the broader macro US entitlement cost issue absolutely key to longer term government fiscal outcomes ahead. But we need to remember that even the extended unemployment benefits alone added over $100 billion to disposable personal income over the last three years.

So back to the issue of retail and how it might help us "see" what lies ahead. It seems pretty darn clear that up to this point, Government stimulus has supported US disposable personal income growth which has allowed consumers to weather the storm of a higher cost of living so far. But we know that personal tax and unemployment extension benefits sunset as the current year comes to a close. Then what? Then what not only for the reality of the US economy and consumption trends in general, but also then what in terms of investment decision making. We hope that watching consumer dynamics as expressed in stock prices will give us clues as what lies ahead. If indeed a higher cost of living for consumers meets up with a reduction in government largesse/stimulus formerly supporting personal income by year end, will the price direction of consumer discretionary stocks tip us off? One relationship that has been very helpful really going back to the stock market highs of 2007 has been the relative performance of consumer discretionary stocks versus consumer staples issues. The staples we as consumers need, the discretionary purchases we as consumers want. And what's the dividing line and often decision point between the two? Disposable personal income.

The chart below we hope is a useful singular tool within the broader analytical toolbox of life. It's the relative performance of the S&P consumer discretionary sector (the XLY) versus the S&P consumer staples sector (the XLP). At least since 2007, this relative price performance ratio has led the direction of the broader stock market. It has also been a leading indicator for the direction of US GDP as a whole. After all, what better describes the character of the US economy at any point in time than the character of consumption?

At the equity market highs of 2007, the relative performance of the consumer discretionary sector compared to the consumer staples stocks put in a "lower high" in price relative to the "higher high" seen in the S&P 500. Clear in hindsight, the discretionary stocks were warning of a slowing in consumption. As is so often the case in the financial markets, "divergences" are extremely important. We personally live by the motto that the most important messages of the markets are seen in pattern or price trend divergences. And this one was on the money.

XLY:XLP Weekly vesrus SPX

In almost mirror image divergence in late 2008 and early 2009, the relationship of the discretionary equity sector to the consumer staples sector put in a "higher low", while the S&P 500 put in a "lower low" in price. Once again the retail sector discretionary versus staples relationship was a leading indicator for both the financial markets and the economy, in essence "telling us" conditions would improve ahead. So looking forward this is one of many indicators regarding the character of US consumption hopefully helpful in decision making.

As of the end of last week, we see yet another very short term divergence between discretionary versus staples stocks set against the broad market characterized by the S&P.

XLY:XLP Daily vesrus SPX

In the current cycle, the discretionary versus staples relative performance ratio has been important not only for documenting and benchmarking the character of consumption, but also because the discretionary stocks have traditionally been considered a high beta (investment risk) sector. In the risk on versus risk off investment environment of the current cycle clearly engendered by the Fed's extravagant monetary policy experimentation, the discretionary sector singularly takes on importance in terms of staying in harmony with the risk on versus risk off ebb and flow character of the financial market for now.

One last retail observation we likewise hope is an important anecdote. A few brief preemptory comments. We all know it is clear that since late summer of last year, the Fed has directly targeted US stock prices for reflation. And reflate they have. Very generically, we know as does the Fed that the top roughly 20% wealth demographic in the US accounts for approximately 60% of personal consumption expenditures. Quite simply, the top 20% can out spend their US wealth demographic peers. The Fed also knows that it's this top 20% wealth demographic that is the most leveraged to higher stock prices vis-à-vis the concentration of equity ownership in the US . So, the Fed clearly inferred that if they could reflate stock prices, they could theoretically reflate aggregate personal consumption spending by this top 20% that would positively impact headline consumption numbers. This is indeed exactly what has happened.

Is there yet something else we can watch that might give us an insight or two as to how the higher end of the consumption food chain in the US feels about life? We'll see how it all works out ahead, but one observation that has indeed been helpful in both of the prior two financial market and real economic cycles has been to keep an eye on very high end retail such as Sotheby's that you see below. Sotheby's has literally put in spike price highs very near the top of each prior market cycle and directly before the onset of both of the last two recessions. Directionally it has been joined at the hip with the broad equity market.

BID versus SPX

Again, just another tool in the analytical tool box we hope can help in completing the ongoing paint by number story that is the financial market. Hopefully by watching the XLY versus XLP ratio in conjunction with high end retail such as Sotheby's will allow us to get a sense for the total high and low end of the consumer market. A market crucial to the character of the US economy and a market that has very much been supporting by Government sponsored tailwinds that are set to die down as we move directly ahead. Up to this point, despite higher costs of energy and food related necessities of life, in aggregate consumers have hung in there. Retail sales have been good. But as we look ahead and Government stimulus to US disposable personal income winds down, will retail sales simply become fair? As per the economic/financial market indicator toolbox of life, what we'll critically need to be on the lookout for is the potential for fractured fair retails.


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