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Consumers Have to Slow Down

The latest survey from the Cambridge Consumer Credit Index on consumer credit card use was sensationalized, even by them. One its homepage, www.cambridgeconsumerindex.com, there is a large teaser graphic with the quote, "46% of Americans are making minimum or no payments on their credit card balances!" Journalists picked up the data and published articles using these statistics. This obviously paints a very grim picture of the U.S. consumer. The only problem is it is not true, based on the data. The survey results revealed that 46% that are making the minimum or no payments are a subset of the 31% of consumers that are extending their credit card payments. Forty-six percent of credit card users are paying their balances off in full each month. This means that about 14% of Americans are making minimum or no payments on their credit cards. This is similar to the results last March when the same question was asked. Granted this is still unhealthy, and there are plenty of concerns regarding the state of consumers and the use of credit. The same survey found that 44% of consumers are taking on additional debt because they do not have the money to pay of the item when they are purchased. This is quite a bit higher than the 24% that used credit because they had to.

Last week, the Federal Reserve released its consumer credit data showing an increase by $13.2 billion. Economists had actually forecasted a drop of $1 billion. The Fed also revised December's $4 billion decline to a $2 billion increase. The fact that consumer credit has grown at all over the past six months is astonishing. Part of the mantra promoting the historic refinancing binge is how homeowners can extract equity out to pay off higher interest rate debt.

Consumer confidence continues to weaken. The ABC News/Money Magazine Consumer Comfort index fell four points to -25 and is within 2 points of the lows set earlier this year. The response to how is the state of the economy dropped ten points to -54, the lowest level since December 1993, when the economy was climbing out of the previous recession. As a point of reference, this component hovered around the -80 level throughout most of 1992. The headline number went as low as -50 in 1992, and was below -40 for most of 1992 and below -20 throughout 1991, 1992, and 1993.& Confidence in California fell almost 19 points to 72.2 in the first quarter according to Chapman University's index of California consumer sentiment. Even more important was the drop in the index measuring durable goods spending, which fell over 33 points to 71.8.

The decline in the stock market is having several rippling effects that will affect the economy for years. Pension returns have been below expected returns and companies have started to fund their pensions through charges to equity. Companies are also reducing the expected return on their pension plans, which will reduce earnings as pension expense will increase. Some companies are trying to push the issue out of the way by changing their retirement plans to 401(k) plans. This will shift the risk onto employees. The past several years have shown that the vast majority of the public is ill-suited to manage something as important as their retirement plan. It is also difficult to get employees to contribute enough to provide for retirement, or to even participate.

A survey conducted by Buck Consultants found that the participation rate fell to 73% in 2002, down from 77% in 1999. Contribution rates are another problem associated with employees managing their own retirement account. According to Vanguard Group the median savings rate dropped to 6% in 2001, from 7% in 1999. While a 100 basis point drop might not seem significant, over the course of thirty years it becomes very significant. By contributing an extra $500 per year for thirty years, earning just 7%, a retiree will have an additional $47,000 at retirement. Most market pundits' forecasts that future returns will be lower than those of recent history. Roger Ibbotson, a leader in investment return analysis, expects stocks to raise no more than 8.5% over the next 20 years. This is quite lower than the 10.2% stocks have averaged over the past 70 years. If the stock market is not going to be the panacea, consumers will have to stash away more for retirement. If a 35 year-old worker wishes to be a millionaire when he retires at 65, a sum that may prove conservative given how inflation appears to be creeping into the economy, he will have to save $8,800 per year if he is able to earn 8% per year. This is almost $2,800 more per year than if he earned 10%. This is 17% of the median family income of $51,000 for families headed by someone 35 to 44 years old. While most workers start saving much earlier, which would reduce the amount needed to save, most do not. Sixty percent of families headed by someone under 35 years old do not have a retirement account. There have also been several accounts of companies suspending their matching contributions. The obviously will alter consumer consumption. As more money is allocated toward savings there will be less available for consumption.

Companies are releasing their 10-Ks this week. It would be wise to check the assumed rate of return for its pension plan. The numbers will be found buried in the footnotes. The SEC stated that any company with an assumed rate of return greater than 9% will have to explain why. There will be a lot of companies reducing their rates, but I would still be leery of any company that maintains a rate of return greater than 8%. Personally, 7% seems much more realistic, if not stretching a bit considering ten-year Treasuries are well under 4.0%. Heck, ten-year BBB bonds are yielding 6.5%. An equal allocation between stocks and bonds means equities have to average 9.5% for a portfolio to earn 8% (assuming bonds are held to maturity). Another indication that future returns will be lower in the future comes from Fidelity Investments. This week, Fidelity announced it lowered its pension return assumption to 7%, from 7.75%.

Over the weekend, Berkshire Hathaway released its 2002 annual report. Warren Buffet's letter to shareholders is considered a must read by a large majority of investors and usually garners a lot of publicity. This year was no exception. This year, Buffet focused on derivatives, overvalued equities and corporate governance. Links to the stories discussing Buffet's letter along with a link to the letter can be found in our news archive section. One aspect of derivative that Buffet failed to discuss is how it actually encourages risky behavior. During non-risky time periods, buying risk is highly profitable; investors simply receive premium payments without having to make any payments due to loss. This attracts buyers and the increased competition pushes down the premiums. At some point risk gets under priced and reserves are underfunded. Once the environment changes and it becomes more risky, there is a rush to sell risk, but buyers are not as prevalent during a risky environment. While selling risk does serve a purpose and makes economic sense, once it get to be a substantial part of the market it suffers just like every other aspect of economics and finance - it creates a fallacy of composition. Dong Noland does a wonderful job at presenting this in a commentary from March 2000, A Derivative Story. The story starts about a page down.

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