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Why The Measure Of “Savings” Is Entirely Wrong

In our recent series on capitalism (Read Here), we were discussing how the implementation of socialism, by its very nature, requires an ability to run unlimited deficits. In that discussion was the following quote:

Deficits are self-financing, deficits push rates down, deficits raise private savings.” – Stephanie Kelton

On the surface, there does seem to be a correlation between surging deficits and increases in private savings, as long as you ignore the long-term trend, or the reality of 80% of Americans in the U.S. today that live paycheck-to-paycheck.

The reality is the measure of “personal savings,” as calculated by the Bureau of Economic Analysis, is grossly inaccurate. However, to know why such is the case, we need to understand how the savings rate is calculated. The website HowMuch.com recently provided that calculation of us. 

As you can see, after the estimated taxes and estimated expenses are paid, there is $6,017 dollars left over for “savings,” or, as the Government figures suggest, an 8%+ savings rate. 

The are multiple problems with the calculation.

  1. It assumes that everyone in the U.S. lives on the budget outlined above
  2. It also assumes the cost of housing, healthcare, food, utilities, etc. is standardized across the country. 
  3. That everyone spends the same percentage and buys the same items as everyone else. 

The cost of living between California and Texas is quite substantial. While the median family income of $78,635 may raise a family of four in Houston, it is probably going to be quite tough in San Francisco.

While those flaws are apparent, the biggest issue is the saving rate is heavily skewed by the top 20% of income earners. This is the same problem that also plagues disposable personal income and debt ratios, as previously discussed  in “America’s Debt Burden Will Fuel The Next Crisis.” To wit:

“The calculation of disposable personal income (which is income less taxes) is largely a guess, and very inaccurate, due to the variability of income taxes paid by households. More importantly, the measure is heavily skewed by the top 20% of income earners, and even more so by the top 5%. As shown in the chart below, those in the top 20% have seen substantially larger median wage growth versus the bottom 80%. (Note: all data used below is from the Census Bureau and the IRS.)”

The interactive graphic below from MagnifyMoney shows the disparity of income versus savings even more clearly.

When you look at the data in this fashion, you can certainly begin to understand the calls for “socialism” by political candidates. The reality is the majority of Americans are struggling just to make ends meet, which has been shown in a multitude of studies. 

“The [2019] survey found that 58 percent of respondents had less than $1,000 saved.” – Gobankingrates.com

Or, as noted by the WSJ:

“The American middle class is falling deeper into debt to maintain a middle-class lifestyle.

Cars, college, houses, and medical care have become steadily more costly, but incomes have been largely stagnant for two decades, despite a recent uptick. Filling the gap between earning and spending is an explosion of finance into nearly every corner of the consumer economy.

Consumer debt, not counting mortgages, has climbed to $4 trillion—higher than it has ever been even after adjusting for inflation.”

When looking at the data, it is hard to suggest that Americans are saving 8% or more of their income.

The differential between incomes and the actual “cost of living” is quite substantial. As Researchers at Purdue University found in their study of data culled from across the globe, in the U.S., $132,000 was found to be the optimal income for “feeling” happy for raising a family of four. (I can attest to this personally as a father of a family of six)

A Gallup survey found it required $58,000 to support a family of four in the U.S. (Forget about being happy, we are talking about “just getting by.”) 

So, while the Government numbers suggest the average American is saving 8% of their income annually, the majority of “savings” is coming from the differential in incomes between the top 20% and the bottom 80%.

In other words, if you are in the “Top 20%” of income earners, congratulations, you are probably saving a chunk of money.

If not, it is likely a very different story.

The “gap” between the “standard of living” and real disposable incomes is shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the “gap.” However, following the “financial crisis,” even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $2654 annual deficit that cannot be filled.

That gap explains why consumer debt is at historic highs and growing each year. If individuals were saving 8% of their money every year, debt balances would at least be flat, if not declining, as they are paid off. 

We can see the inconsistency between the “saving rate” and the requirement to sustain the “cost of living” by comparing the two. Beginning in 2009, it required the entire income of wage earners plus debt just to maintain the standard of living. The gap between the reported savings rate, and reality, is quite telling.

While Stephanie Kelton suggests that running massive deficits increases saving rates, and pose not economic threat as long as their is no inflation, the data clearly suggests this isn’t the case.

Savings rates didn’t fall in the ’80s and ’90s because consumers decided to just spend more. If that was the case, then economic growth rates would have been rising on a year-over-year basis. The reality, is that beginning in the 1980’s, as the economy shifted from a manufacturing to service-based economy, productivity surged which put downward pressure on wage and economic growth rates. Consumers were forced to lever up their household balance sheet to support their standard of living. In turn, higher levels of debt-service ate into their savings rate.

The problem today is not that people are not “saving more money,” they are just spending less as weak wage growth, an inability to access additional leverage, and a need to maintain debt service restricts spending.

That is unless you are in the top 20% of income earners. 

Peak Buybacks? Has Corporate Indulgence Hit Its Limits

Since the passage of “tax cuts,” in late 2017, the surge in corporate share buybacks has become a point of much debate. As I previously wrote, stock buybacks are once again on pace to set a new record in 2019. To wit:

“A recent report from Axios noted that for 2019, IT companies are again on pace to spend the most on stock buybacks this year, as the total looks set to pass 2018’s $1.085 trillion record total.”

The reason companies spend billions on buybacks is to increase bottom-line earnings per share which provides the “illusion” of increasing profitability to support higher share prices. Since revenue growth has remained extremely weak since the financial crisis, companies have become dependent on inflating earnings on a “per share” basis by reducing the denominator. 

“As the chart below shows, while earnings per share have risen by over 360% since the beginning of 2009; revenue growth has barely eclipsed 50%.”

As shown by BofA, in 2019, cumulative buybacks are up +20% on an annualized basis, with the 4-week average reaching some of the highest levels on record. This is occurring at a time when earnings continue to come under pressure due to tariffs, slower consumption, and weaker economic growth.

While share repurchases are not necessarily a bad thing, it is just the “least best” use of companies liquid cash. Instead of using cash to expand production, increase sales, acquire competitors, make capital expenditures, or buy into new products or services which could provide a long-term benefit; the cash is used for a one-time boost to earnings on a per-share basis.

Yes, share purchases can be good for current shareholders if the stock price rises, but the real beneficiaries of share purchases are insiders where changes in compensation structures have become heavily dependent on stock-based compensation. Insiders regularly liquidate shares which were “given” to them as part of their overall compensation structure to convert them into actual wealth. As the Financial Times recently penned:

Corporate executives give several reasons for stock buybacks but none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay and in the short-term buybacks drive up stock prices.

That statement was further supported by a study from the Securities & Exchange Commission which found the same issues:

  • SEC research found that many corporate executives sell significant amounts of their own shares after their companies announce stock buybacks, Yahoo Finance reports.

Not surprisingly, as corporate share buybacks are hitting record highs; so is corporate insider selling.

What is clear, is that the misuse, and abuse, of share buybacks to manipulate earnings and reward insiders has become problematic. As John Authers recently pointed out:

“For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices.”

In other words, between the Federal Reserve injecting a massive amount of liquidity into the financial markets, and corporations buying back their own shares, there have been effectively no other real buyers in the market. 

Less Bang For The Buck

While investors have chased asset prices higher over the last couple of years on hopes of a “trade deal,” more accommodation from Central Banks, or hope the “bull market will never end,” the impact of share buybacks on asset prices is fading.

The chart below is the S&P 500 Buyback Index versus the Total Return index. Following the financial crisis, when companies changed from “splitting shares” to “reducing shares,” there has been a marked outperformance by those companies.

However, while corporate buybacks have accounted for the majority of net purchases of equities in the market, the benefit of pushing asset prices higher is waning. Outside of the brief moment in 2018 when tax cuts were implemented, which allowed companies to repatriate overseas cash, the buyback index has underperformed.

Without that $4 trillion in stock buybacks, not to mention the $4 trillion in liquidity from the Federal Reserve, the stock market would not have been able to rise as much as it has. Given high valuations, weakening earnings, and sluggish economic growth, without continued injections of liquidity going forward, the risk of a substantial repricing of assets has risen.

A more opaque problem is that share repurchases have increasingly been done with the use of leverage. The ongoing suppression of interest rates by the Federal Reserve led to an explosion of debt issued by corporations. Much of the debt was not used for mergers, acquisitions or capital expenditures but for the funding of share repurchases and dividend issuance.

The explosion of corporate debt in recent years will become problematic during the next bear market. As the deterioration in asset prices increases, many companies will be unable to refinance their debt, or worse, forced to liquidate. With the current debt-to-GDP ratio at historic highs, it is unlikely this will end mildly.

This is something Dallas Fed President Robert Kaplan warned about:

U.S. nonfinancial corporate debt consists mostly of bonds and loans. This category of debt, as a percentage of gross domestic product, is now higher than in the prior peak reached at the end of 2008.

A number of studies have concluded this level of credit could ‘potentially amplify the severity of a recession,’

The lowest level of investment-grade debt, BBB bonds, has grown from $800 million to $2.7 trillion by year-end 2018. High-yield debt has grown from $700 million to $1.1 trillion over the same period. This trend has been accompanied by more relaxed bond and loan covenants, he added.

It’s only a problem if a recession occurs.

According to CNN, 53 percent of chief financial officers expect the United States to enter a recession prior to the 2020 presidential election. That information was sourced from the Duke University/CFO Global Business Outlook survey released on Wednesday. And two-thirds predict a downturn by the end of next year. While a slight downturn may not amount to a recession, it certainly means CFOs are taking the initiative to prepare for the worst.”

This is a very important point.

CEO’s make decisions on how they use their cash. If concerns of a recession persist, it is likely to push companies to become more conservative on the use of their cash, rather than continuing to repurchase shares. If that source of market liquidity fades, the market will have a much tougher time maintaining current levels, or going higher.

Summary

While share repurchases by themselves may indeed be somewhat harmless, it is when they are coupled with accounting gimmicks and massive levels of debt to fund them in which they become problematic.

The biggest issue was noted by Michael Lebowitz:

“While the financial media cheers buybacks and the SEC, the enabler of such abuse idly watches, we continue to harp on the topic. It is vital, not only for investors but the public-at-large, to understand the tremendous harm already caused by buybacks and the potential for further harm down the road.”

Money that could have been spent spurring future growth for the benefit of investors was instead wasted only benefiting senior executives paid on the basis of fallacious earnings-per-share.

As stock prices fall, companies that performed un-economic buybacks are now finding themselves with financial losses on their hands, more debt on their balance sheets, and fewer opportunities to grow in the future. Equally disturbing, the many CEO’s who sanctioned buybacks, are much wealthier and unaccountable for their actions.

For investors betting on higher stock prices, the question is whether we have now seen “peak buybacks?”

The Disconnect Between The Markets & Economy Has Grown

A couple of years ago, I wrote an article discussing the disconnect between the markets and the economy. At that time, the Fed was early into their rate hiking campaign. Talks of tax cuts from a newly elected President filled headlines, corporate earnings were growing, and there was a slew of fiscal stimulus from the Government to deal with the effects of 3-major hurricanes and 2-devastating wildfires. Now, the Fed is cutting rates, so it is time to revisit that analysis.

Previously, the consensus for the rise in capital markets was the tax cuts, and low levels of interest rates made stocks the only investment worth having. 

Today, rates have risen, economic growth both domestically and globally has weakened, and corporate profitability has come under pressure. However, since the Fed is cutting rates, hinting at expanding their balance sheet, and a “trade deal” is at hand, stocks are the only investment worth having.

In other words, regardless of the economic or fundamental backdrop, “stocks are the only investment worth having.” 

I am not so sure that is the case.

Let’s begin by putting the markets into perspective.

Yes, the markets are flirting with “all-time highs.” While this certainly sounds impressive, for many investors, they have just started making money on their investments from the turn of the century. As we noted in “The Moment You Know You Know, You Know,” what is often forgotten is the massive amount of “time” lost in growing capital to meet retirement goals.

This is crucially important to understand as was something I addressed in “Stocks – The Great Wealth Equalizer:”

“By the time that most individuals achieve a point in life where incomes and savings rates are great enough to invest excess cash flows, they generally do not have 30 years left to reach their goal. This is why losing 5-7 years of time getting back to “even” is not a viable investment strategy.

The chart below is the inflation-return of $1000 invested in 1995 with $100 added monthly. The blue line represents the impact of the investment using simple dollar-cost averaging. The red line represents a “lump sum” approach. The lump-sum approach utilizes a simple weekly moving average crossover as a signal to either dollar cost average into a portfolio OR moves to cash. The impact of NOT DESTROYING investment capital by buying into a declining market is significant.”

“Importantly, I am not advocating “market timing” by any means. What I am suggesting is that if you are going to invest into the financial markets, arguably the single most complicated game on the planet, then you need to have some measure to protect your investment capital from significant losses.

While the detrimental effect of a bear market can be eventually recovered, the time lost during that process can not. This is a point consistently missed by the ever bullish media parade chastising individuals for not having their money invested in the financial markets.”

However, let’s set aside that point for the moment, and discuss the validity of the argument of the rise of asset prices is simply a reflection of economic strength.

Assuming that individuals are “investing” in companies, versus speculating on price movement, then the investment process is a “bet” on future profitability of the company. Since, companies derive their revenue from consumption of their goods, products, and services; it is only logical that stock price appreciation, over the long-term, has roughly equated to economic growth. However, during shorter time-frames, asset prices are affected by investor psychology which leads to “boom and bust” cycles. This is the situation currently, which can be seen by the large disconnect between current economic growth and asset prices.

Since January 1st of 2009, through the end of the second quarter of 2019, the stock market has risen by an astounding 164.90% (inflation-adjusted). However, if we measure from the March 9, 2009 lows, the percentage gain explodes to more than 200%. With such a significant gain in the financial markets, we should see a commensurate indication of economic growth.

The reality is that after 3-massive Federal Reserve driven “Quantitative Easing” programs, a maturity extension program, bailouts of TARP, TGLP, TGLF, etc., HAMP, HARP, direct bailouts of Bear Stearns, AIG, GM, bank supports, etc., all of which total more than $33 Trillion, the economy grew by just $3.87 Trillion, or a whopping 24.11% since the beginning of 2009. The ROI equates to $8.53 of interventions for every $1 of economic growth.

Not a very good bargain.

We can look at this another way.

The stock market has returned almost 103.6% since the 2007 peak, which is more than 4-times the growth in GDP and nearly 3-times the increase in corporate revenue. (I have used SALES growth in the chart below as it is what happens at the top line of income statements and is not AS subject to manipulation.)

The all-time highs in the stock market have been driven by the $4 trillion increase in the Fed’s balance sheet, hundreds of billions in stock buybacks, and valuation (PE) expansion. With Price-To-Sales ratios and median stock valuations near the highest in history, one should question the ability to continue borrowing from the future?

Speaking of rather extreme deviations, another concern for the detachment of the markets from more basic economic realities, the deviation of reported earnings from corporate profits after-tax, is at historical extremes.

These sharp deviations tend to occur in late market cycles when “excess” from speculation has reached extremes. Recessions tend to follow as a “reversion to the mean occurs.

While, earnings have surged since the end of the last recession, which has been touted as a definitive reason for higher stock prices, it is not all as it would seem.

Earnings per share are indeed an important driver of markets over time. However, the increase in profitability has not come strong increases in revenue at the top of the income statement. The chart below shows the deviation between the widely touted OPERATING EARNINGS (earnings before all the “bad” stuff) versus REPORTED EARNINGS which is what all historical valuations are based. I have also included revenue growth, as well.

This is not a new anomaly, but one which has been a consistent “meme” since the end of the financial crisis. As the chart below shows, while earnings per share have risen by over 360% since the beginning of 2009; revenue growth has barely eclipsed 50%.

While suppressed wage growth, layoffs, cost-cutting, productivity increases, accounting gimmickry, and stock buybacks have been the primary factors in surging profitability, these actions have little effect on revenue growth. The problem for investors is all of the gimmicks to win the “beat the estimate game” are finite in nature. Eventually, real rates of revenue growth will matter. However, since suppressed wages and interest rates have cannibalized consumer incomes – there is nowhere left to generate further sales gains from in excess of population growth.

Left Behind

While Wall Street has significantly benefited from the Fed’s interventions, Main Street has not. Over the past few years, as asset prices surged higher, there has been very little translation into actual economic prosperity for a large majority of Americans. This is reflective of weak wage, economic, and inflationary growth which has led to a surge in consumer debt to record levels.

Of course, weak economic growth has led to employment growth that is primarily a function of population growth. As I addressed just recently:

“Employment should increase to accommodate for the increased demand from more participants in the economy. Either that or companies resort to automation, off-shoring, etc. to increase rates of production without increases in labor costs. The chart below shows the total increase in employment versus the growth of the working-age population.”

While reported unemployment is hitting historically low levels, there is a swelling mass of uncounted individuals that have either given up looking for work or are working multiple part-time jobs. This can be seen below which shows those “not in labor force,” as a percent of the working-age population, skyrocketing.

If employment was indeed as strong as reported by government agencies, then social benefits would not be comprising a record high of 22% of real disposable incomes. 

Without government largesse, many individuals would literally be living on the street. The chart above shows all the government “welfare” programs and current levels to date. While unemployment insurance has hit record lows following the financial crisis, social security, Medicaid, Veterans’ benefits and other social benefits have continued to rise and have surged sharply over the last few months.

With 1/5 of incomes dependent on government transfers, it is not surprising that the economy continues to struggle as recycled tax dollars used for consumption purposes have virtually no impact on the overall economy.

Conclusion

While financial markets have surged to “all-time highs,” the majority of Americans who have little, or no, vested interest in the financial markets have a markedly different view. While the Fed keeps promising with each passing year the economy will come roaring back to life, the reality has been that all the stimulus and financial support hasn’t been able to put the broken financial transmission system back together again.

Amazingly, more than two-years following the initial writing of this article, the gap between the markets and the economy has grown even wider. Eventually, the current disconnect between the economy and the markets will merge.

I bet such a convergence will likely not be a pleasant one.

Everyone’s In The Pool

With the market breaking out to all-time highs, the media has started to once again reach for their party hats as headlines suggest clear sailing for investors ahead.

After all, why not?  We have run one of the longest stretches in history without a 5%, much less a 10% decline. Threats of nuclear war, hurricanes, disaster, fires, earthquakes, and civil unrest have failed to unnerve investors. It seems all that has been missed was famine and pestilence.

Nonetheless, the breakout is indeed bullish, and signals the continuation of the bullish trend. However, such does not mean there are more than sufficient reasons to remain cautious. As noted on Tuesday, earnings growth remains weak outside of share buybacks, along with top line revenue. There is scant evidence of economic resurgence outside of a restocking cycle bounce, and inflationary pressures globally remain nascent. But such concerns, and I am not even sure the “4-horseman of the apocalypse” would make a difference, are “trumped,” by the ongoing global central bank interventions.

Not surprisingly, while it took individuals time to develop their “Pavlovian” response to the ringing of the “BTFD” bell, they have now fully complied as measured by the Investment Company Institute (ICI).

As shown in the chart above, as asset prices have escalated, so have individuals appetite to chase risk. The herding into equity ETF’s suggest that investors have simply thrown caution to the wind.

The same can be seen for the American Association of Individual Investors as shown below.

While the ICI chart above shows “net flows,” the AAII chart shows percentage allocated to stocks versus cash. With cash levels at the lowest level since 1997, and equity allocations near the highest levels since 1999 and 2007, it also suggests investors are now functionally “all in.” 

With net exposure to equity risk by individuals at historically high levels, it suggests two things:

  1. There is little buying left from individuals to push markets marginally higher, and;
  2. The stock/cash ratio, shown below, is at levels normally coincident with more important market peaks.

Here is the point, despite ongoing commentary about mountains of cash on the sidelines, this is far from the case. This leaves the current advance in the markets almost solely in the realm of Central Bank activity.

Of course, there is nothing wrong with that…until there is.

Which brings us to the ONE question everyone should be asking.

“If the markets are rising because of expectations of improving economic conditions and earnings, then why are Central Banks pumping liquidity like crazy?”

Despite the best of intentions, Central Bank interventions, while boosting asset prices may seem like a good idea in the short-term, in the long-term has had a negative impact on economic growth. As such, it leads to the repetitive cycle of monetary policy.

  1. Using monetary policy to drag forward future consumption leaves a larger void in the future that must be continually refilled.
  2. Monetary policy does not create self-sustaining economic growth and therefore requires ever larger amounts of monetary policy to maintain the same level of activity.
  3. The filling of the “gap” between fundamentals and reality leads to consumer contraction and ultimately a recession as economic activity recedes.
  4. Job losses rise, wealth effect diminishes and real wealth is destroyed. 
  5. Middle class shrinks further.
  6. Central banks act to provide more liquidity to offset recessionary drag and restart economic growth by dragging forward future consumption. 
  7. Wash, Rinse, Repeat.

If you don’t believe me, here is the evidence.

The stock market has returned more than 60% since 2007 peak, which is more than three times the growth in corporate sales growth and 30% more than GDP. The all-time highs in the stock market have been driven by the $4.5 trillion increase in the Fed’s balance sheet, hundreds of billions in stock buybacks, PE expansion, and ZIRP.

In turn, this has driven the average valuation of stocks to the highest ratio in history.

Which, as noted, has been driven by a debt-driven binge of share repurchases to boost bottom line earnings.

What could possibly go wrong?

However, whenever there is a discussion of valuations, it is invariably stated that “low rates justify higher valuations.” 

Maybe. But the argument suggests rates are low BECAUSE the economy is healthy and operating near full capacity. However, the reality is quite different as the always insightful Dr. John Hussman pointed out this past week:

“Make no mistake: the main contributors to the illusion of permanent prosperity have been decidedly cyclical factors.

Again, when interest rates are low because growth is also low, no valuation premium is ‘justified’ at all. In the present environment, investors are inviting disastrous losses by paying the highest S&P 500 price/revenue ratio in history (outside of the single week of the 2000 market high) and the highest median price/revenue ratio in history across S&P 500 component stocks (more than 50% beyond the 2000 peak, because extreme valuations in that episode were focused on much narrower subset of stocks than at present). Glorious past returns and record valuations are a Potemkin Village with a barren field behind it.”

There are virtually no measures of valuation which suggest making investments today, and holding them for the next 20-30 years, will work to any great degree.

That is just the math.

Which brings me to something Michael Sincere’s once penned:

“At market tops, it is common to see what I call the ‘high-five effect’ — that is, investors giving high-fives to each other because they are making so much paper money. It is happening now. I am also suspicious when amateurs come out of the woodwork to insult other investors.”

Michael’s point is very apropos, particularly today. It is interesting that prior to the election the majority of analysts, media and investors were “certain” the market would crash if Trump was elected. Since the election, it’s “high-fives and pats on the back.” 

While nothing has changed, the confidence of individuals and investors has surged. Of course, as the markets continue their relentless rise, investors begin to feel “bullet proof” as investment success breeds over-confidence.

The reality is that strongly rising asset prices, particularly when driven by emotional exuberance, “hides” investment mistakes in the short term. Poor, or deteriorating, fundamentals, excessive valuations and/or rising credit risk is often ignored as prices increase. Unfortunately, it is only after the damage is done that the realization of those “risks” occurs.

As Michael stated:

“Most investors believe the Fed will protect their investments from any and all harm, but that cannot go on forever. When the Fed attempts to extricate itself from the market one day, that is when the music stops, and the blame game begins.”

In the end, it is crucially important to understand that markets run in full cycles (up and down). While the bullish “up” cycle lasts twice as long as the bearish “down” cycle, the damage to investors is not a result of lagging markets as they rise, but in capturing the inevitable reversion. This is something I discussed in “Bulls And Bears Are Both Broken Clocks:”

“In the end, it does not matter IF you are ‘bullish’ or ‘bearish.’  The reality is that both ‘bulls’ and ‘bears’ are owned by the ‘broken clock’ syndrome during the full-market cycle. However, what is grossly important in achieving long-term investment success is not necessarily being ‘right’ during the first half of the cycle, but by not being ‘wrong’ during the second half.

The markets are indeed in a liquidity-driven up cycle currently. With margin debt near peaks, stock prices in a near vertical rise and “junk bond yields” near record lows, the bullish media continues to suggest there is no reason for concern.

The support of liquidity is being extracted by the Federal Reserve as they simultaneously tighten monetary policy by raising interest rates. Those combined actions, combined with excessive exuberance and risk taking, have NEVER been good for investors over the long term.

At market peaks – “everyone’s in the pool.”

Consumer Credit & The American Conundrum

What to do?  This is not as an innocuous question as one might think. For most American families, who have to balance their living standards to their income, they face this conundrum each and every month.  Today, more than ever, the walk to the end of the driveway has become a dreaded thing as bills loom large in the dark crevices of the mailbox.

What to do?

In a continuation of last week’s discussion on consumer debt, the conundrum exists because there is not enough money to cover the costs of the current living standard.

“The average family of four have few choices available to them as discretionary spending becomes problematic for the bottom 80% of the population whose wage growth hasn’t kept up with the standard of living.”

The burden of debt that was accumulated during the credit boom can’t simply be disposed of. Many can’t sell their house because they can’t qualify to buy a new one and the cost to rent are now higher than current mortgage payments in many places. There is no ability to substantially increase disposable incomes because of deflationary wage pressures, and despite the mainstream spin on recent statistical economic improvements, the burdens on the average American family are increasing.

Nothing brought this to light more than the recent release of the Fed’s Report on “The Economic Well-Being Of U.S. Households.” The overarching problem can be summed up in one chart:

Of course, the recent rise in consumer credit to all-time highs supports that analysis.

Don’t be fooled by the rise in “student loan” debt either. That is NOT representative of a mass hoard of individuals all clamoring into classrooms across the country to garner the benefits of higher education. According to a 2016 Student Loan Hero survey, individuals have other plans for student loan funds which are easy to acquire.

Or as Bloomberg noted in their survey, 1-in-5 American students will use their student loans to pay for expenses such as vacations, dining out and entertainment. To wit:

“Texas A&M graduate Eric Hazard recalls the excitement of student loan refund day.

‘Checks were celebrated across the campus as almost like a bonus for being a college kid. [Students] would go directly to the bank to cash it. I bought electronics for my dorm room and drinks. You know you have to pay it back, but you don’t have a timeline in your mind about what that was going to look like. I just knew it would happen later.'”

Of course, the problem comes when the bills come due. Can you spell “d-e-l-i-q-u-e-n-c-y.”

So, therein lies the “Great American Consumer Conundrum.” If 70% of the economy is driven by personal consumption, what happens when consumers simply hit the wall?

There is a limit.

Under more normal circumstances rising consumer credit would mean more consumption. The rise in consumption should, in theory, led to stronger rates of economic growth. I say, in theory, only because the data doesn’t support the claim.

Prior to 1980, when the amount of debt used to support consumption was fairly stagnant, the economy, wages, and personal consumption expanded. However, as I noted previously, that all changed with financial deregulation in the early 80’s which fostered three generations of debt driven excesses.

In the past, if they wanted to expand their consumption beyond the constraint of incomes they turned to credit in order to leverage their consumptive purchasing power. Steadily declining interest rates and lax lending standards put excess credit in the hands of every American.  (Seriously, my dog Jake got a Visa in 1999 with a $5000 credit limit)  This is why during the 80’s and 90’s, as the ease of credit permeated its way through the system, the standard of living seemingly rose in America even while economic growth rate slowed in America along with incomes.

Therefore, as the gap between the “desired” living standard and disposable income expanded it led to a decrease in the personal savings rates and increase in leverage. It is a simple function of math. But the following chart shows why this has likely come to the inevitable conclusion, and why tax cuts and reforms are unlikely to spur higher rates of economic growth.

Beginning in 2009, the gap between the real disposable incomes and the cost of living was no longer able to be filled by credit expansion. In other words, as opposed to prior 1980, the situation is quite different and a harbinger of potentially bigger problems ahead. The consumer is no longer turning to credit to leverage UP consumption – they are turning to credit to maintain their current living needs.

There are currently clear signs of stress emerging from credit. Commercial lending has taken a sharp dive as delinquencies have risen. These are signs of both a late stage economic expansion and a weakening environment.

As incomes remain weak, the real-world inflationary pressures of food, energy, medical and utilities have consumed more of discretionary incomes. This is why dependency on social support systems now comprise a record level of disposable incomes.

“Without government largesse, many individuals would literally be living on the street. The chart above shows all the government “welfare” programs and current levels to date. The black line represents the sum of the underlying sub-components.  While unemployment insurance has tapered off after its sharp rise post the financial crisis, social security, Medicaid, Veterans’ benefits and other social benefits have continued to rise.

Importantly, for the average person, these social benefits are critical to their survival as they make up more than 22% of real disposable personal incomes. With 1/5 of incomes dependent on government transfers, it is not surprising that the economy continues to struggle as recycled tax dollars used for consumption purposes have virtually no impact on the overall economy.”

It is hard to make the claim that the economy is on the verge of recovery with statistics like that. Of course, it is the real reason why after 9-years of “emergency measures” from Central Banks globally, they are still using “emergency measures” despite claiming monetary policy victory.

It isn’t just about the “baby boomers,” either. Millennials are haunted by the same problems, with 40%-ish unemployed, or underemployed, and living back home with parents. In turn, parents are now part of the “sandwich generation” that are caught between taking care of kids and elderly parents. The rise in medical costs and healthcare goes unabated consuming more of their incomes.

Hopefully, the recent upticks in the economic data are more than just the temporary “restocking cycles” we have seen repeatedly over the last 8-years. Hopefully, the current Administration will achieve some part of their legislative agenda to help boost economic growth. Hopefully, international economies can continue their growth trends as they account for 40% of corporate profits. Hopefully, an economic cycle that is already the 3rd longest in history with the lowest annual growth rate, can continue indefinitely into the future.

But that is an awful lot of hoping.

Yes, You Should Be Concerned With Consumer Debt

Just recently the Federal Reserve Bank of New York released its quarterly survey of the composition and balances of consumer debt. Importantly, it was the fact that total indebtedness reached a new all-time record that sent the mainstream media abuzz with questions about the economic implications. Here is the graphic that accompanied the commentary.

One of the more interesting points made, in order to support the bullish narrative, was that record levels of debt is irrelevant because of the rise in disposable personal incomes. The following chart was given as evidence to support that claim.

Looks pretty good, as long as you don’t scratch too deeply. Let’s scratch a little.

There are several problems with this analysis.

First, the calculation of disposable personal income, income less taxes, is largely a guess and very inaccurate due to the variability of income taxes paid by households.

Secondly, but most importantly, the measure is heavily skewed by the top 20% of income earners, needless to say, the top 5%. As shown in the chart below, those in the top 20% have seen substantially larger median wage growth versus the bottom 80%.

(Note: all data used below is from the Census Bureau and the IRS.)

Lastly, disposable incomes and discretionary incomes are two very different animals. Discretionary income is what is left of disposable incomes after you pay for all of the mandatory spending like rent, food, utilities, health care premiums, insurance, etc. According to a Gallup survey, it requires about $53,000 a year to maintain a family of four in the United States. For 80% of Americans, this is a problem even on a GROSS income basis.

This is why record levels of consumer debt is a problem. There is simply a limit to how much “debt” each household can carry even at historically low interest rates.

It is also the primary reason why we can not have a replay of the 1980-90’s.

“Beginning 1983, the secular bull market of the 80-90’s began. Driven by falling rates of inflation, interest rates, and the deregulation of the banking industry, the debt-induced ramp up of the 90’s gained traction as consumers levered their way into a higher standard of living.”

“While the Internet boom did cause an increase in productivity, it also had a very deleterious effect on the economy.

As shown in the chart above, the rise in personal debt was used to offset the declines in personal income and savings rates. This plunge into indebtedness supported the ‘consumption function’ of the economy. The ‘borrowing and spending like mad’ provided a false sense of economic prosperity.

During the boom market of the 1980’s and 90’s consumption, as a percentage of the economy, grew from roughly 61% to 68% currently. The increase in consumption was largely built upon a falling interest rate environment, lower borrowing costs, and relaxation of lending standards. (Think mortgage, auto, student and sub-prime loans.)

In 1980, household credit market debt stood at $1.3 Trillion. To move consumption, as a percent of the economy, from 61% to 67% by the year 2000 it required an increase of $5.6 Trillion in debt.

Since 2000, consumption as a percent of the economy has risen by just 2% over the last 17 years, however, that increase required more than a $6 Trillion in debt.

The importance of that statement should not be dismissed. It has required more debt to increase consumption by 2% of the economy since 2000 than it did to increase it by 6% from 1980-2000. 

The problem is quite clear. With interest rates already at historic lows, consumers already heavily leveraged and economic growth running at sub-par rates – there is not likely a capability to increase consumption as a percent of the economy to levels that would replicate the economic growth rates of the past.

This can be clearly seen in the following chart of personal consumption expenditures (PCE) and debt. Up until 2000, debt expansion and PCE rose in tandem. But beginning in 2000, as economic growth rates plunged to 2%ish, which isn’t strong enough to foster job growth beyond population growth, debt took the lead in supporting consumption. This was primarily centered on those in the bottom 80% who were simply trying to maintain their current standard of living.

There is a vast difference between the level of indebtedness (per household) for those in the bottom 80% versus those in the top 20%.

Of course, the only saving grace for many American households is that artificially low interest rates have reduced the average debt service levels. Unfortunately, those in the bottom 80% are still having a large chunk of their median disposable income eaten up by debt payments. This reduces discretionary spending capacity even further.

The problem is quite clear. With interest rates already at historic lows, the consumer already heavily leveraged and wage growth stagnant, the capability to increase consumption to foster higher rates of economic growth is limited.

With respect to those who say “the debt doesn’t matter,” I respectfully argue that you looking at a very skewed view of the world driven by those at the top.

Yes, the ongoing interventions by the Federal Reserve have certainly boosted asset prices higher, but that has only served to widen the wealth gap between the top 20% of individuals that have dollars invested in the financial markets and everyone else. What monetary interventions have failed to accomplish is an increase in production to foster higher levels of economic activity.

Corporate profitability is illusory also as it has primarily been a function of cost cutting, increased productivity, stock buybacks, and accounting gimmicks. While this has certainly provided an illusion of economic prosperity on the surface, however, the real economy remains very subject to actual economic activity. It is here that the inability to re-leverage balance sheets, to any great degree, to support consumption provides an inherent long-term headwind to economic prosperity.

With the average American still living well beyond their means, the reality is that economic growth will remain mired at lower levels as savings continue to be diverted from productive investment into debt service.  The issue, of course, is not just a central theme to the U.S. but to the global economy as well.  After eight years of excessive monetary interventions, global debt levels have yet to be resolved.

Debt is a negative thing for the borrower. It has been known to be such a thing even in biblical times as quoted in Proverbs 22:7:

“The borrower is the slave to the lender.”

Debt acts as a “cancer” on an individual’s wealth as it siphons potential savings from income to service the debt. Rising levels of debt, means rising levels of debt service that reduces actual disposable personal incomes that could be saved or reinvested back into the economy.

The mirage of consumer wealth has been a function of surging debt levels. “Wealth” is not borrowed, but “saved,” and this is a lesson that too few individuals have learned.

Until the deleveraging cycle is allowed to occur, and household balance sheets return to more sustainable levels, the attainment of stronger, and more importantly, self-sustaining economic growth could be far more elusive than currently imagined.

Has The Fed Completely Lost Control

An interesting thing happened on the way to World Domination, uhh, I mean “Stability” – the data quit cooperating with the Federal Reserve’s carefully devised plan.

Just recently the Federal Reserve quit updating their carefully constructed “Labor Market Conditions Index” which failed to support their ongoing claims of improving employment conditions. The chart below is the last iteration before it was discontinued which showed a clear deterioration in underlying strength.

But to add insult to injury, inflationary pressures have not resurfaced as anticipated despite years of ultra-low interest rates and a flood of liquidity into the financial system. This has now led the Fed to start considering whether their cornerstone inflation model still works. As Bloomberg noted recently:

Federal Reserve officials are looking under the hood of their most basic inflation models and starting to ask if something is wrong.

Minutes from the July 25-26 Federal Open Market Committee meeting showed a revealing debate over why the economy isn’t producing more inflation in a time of easy financial conditions, tight labor markets and solid economic growth.

The central bank has missed its 2 percent price goal for most of the past five years. Still, a majority of FOMC participants favor further rate increases. The July minutes showed an intensifying debate over whether that is the right policy response.”

Of course, nowhere is the Fed’s inability to forecast efficiently than in their own published forecast they began producing in 2011 to be more “transparent” with the financial markets. The results have been spectacularly disastrous.

However, despite the clear evidence that economic growth is hardly running at levels that would be considered “strong” by any measure, the Fed has decided the best path forward to continue “tightening” monetary policy. This is ironic considering the ENTIRE PURPOSE of TIGHTENING monetary policy is to SLOW economic growth to keep inflationary pressures at bay. 

The disconnect between Fed policy and the economy is nothing new. This was a point recently made by Neal Kashkari:

“At the same time the unemployment rate was dropping, core inflation was also dropping, and inflation expectations remained flat to slightly down at very low levels. We don’t yet know if that drop in core inflation is transitory. In short, the economy is sending mixed signals: a tight labor market and weakening inflation.”

Kashkari is right in worrying that the Fed is placing too much faith on the Phillips Curve which predicts a tighter reverse relationship between the unemployment rate and inflation than has actually been seen in recent years. This is particularly the case given the problems with the underlying U-3 employment rate calculation as discussed just recently. To wit:

“Has there been ‘job creation’ since the last recession? Absolutely.

If you take a look at the actual number of those “counted” as employed, that number has risen from the recessionary trough. Unfortunately, employment remains far below the long-term historical trend that would suggest healthy levels of economic growth. Currently, the deviation from the long-term trend is the widest on record and has made NO improvement since the recessionary lows.

However, as it relates to economic growth, what is always overlooked is the number of new entrants into the working-age population each month.”

The problem for the Fed in making the decision to discontinue their own Labor Market Conditions Index, which is likely providing a more accurate picture of the real conditions, is being forced to remain tied to an outdated U-3 employment index. As noted recently by Morningside Hill:

“There is sufficient evidence to suggest the Bureau of Labor Statistics (BLS) calculation method has been systemically overstating the number of jobs created, especially in the current economic cycle. Furthermore, the BLS has failed to account for the rise in part-time and contractual work arrangements, while all evidence points to a significant and rapid increase in the so-called contingent workforce as full-time jobs are being replaced by part-time positions, resulting in double and triple counting of jobs via the Establishment Survey.

Lastly, a full 93% of the new jobs reported since 2008 and 40% of the jobs in 2016 alone were added through the business birth and death model – a highly controversial model which is not supported by the data. On the contrary, all data on establishment births and deaths point to an ongoing decrease in entrepreneurship.”

This last point was something I have addressed many times previously, the chart below shows the actual employment roles in the U.S. when stripping out the Birth/Death Adjustment model. With such a large overstatement of actual employment, the flawed model does support the idea of a tight labor market.

Unfortunately, despite arguments to the contrary, there is little support for why the bulk of Americans that should be working, simply aren’t.

This is where Neal goes on to identify the prevalent risk for the Fed:

“In the 1970s, that faith led the Fed to keep rates too low, leading to very high inflation. Today, that same faith may be leading the Committee to repeatedly (and erroneously) forecast increasing inflation, resulting in us raising rates too quickly and continuing to undershoot our inflation target.”

Let me be clear.

The Fed is not actually concerned with employment or price stability.

They are vastly more concerned with keeping the financial markets running smoothly. Their goal, which was clearly stated back in 2010, was simply to force individuals to get their money out of “savings accounts” and put it to work either through consumption or investment. They enforced that mandate with a “club” of zero percent interest rates.

The problem for them now, is trying to reign that back in before the next recession. This puts the Federal Reserve in a very difficult position with very few options. While increasing interest rates may not “initially” impact asset prices or the economy, it is a far different story to suggest that they won’t.

Unfortunately, what the Federal Reserve is quickly realizing is they have become trapped by their own “data-dependent” analysis. Despite ongoing commentary of improving labor markets and economic growth, their own indicators have continued to suggest something very different.

Now they are simply considering abandoning those tools.

Is this a sign they have lost control of monetary policy?

Probably.

Will this ultimately lead to a policy misstep the disrupts the financial, and most importantly, the credit markets?

Definitely.

Why do I say that? Because there have been absolutely ZERO times in history that the Federal Reserve has begun an interest-rate hiking campaign that has not eventually led to a negative outcome.

While the Federal Reserve clearly should not raise rates further in the current environment, it is clear they will remain on their current path. This is because, I believe, the Fed understands that economic cycles do not last forever, and we are closer to the next recession than not. While raising rates will accelerate a potential recession and a significant market correction, from the Fed’s perspective it might be the “lesser of two evils.” Being caught near the “zero bound” at the onset of a recession leaves few options for the Federal Reserve to stabilize an economic decline.

In other words, they already realize they are screwed.

The Great Disconnect: Markets vs. Economy

The general consensus is the rise in capital markets, despite global weakness, geopolitical risks and sluggish employment and wage growth, is clearly a sign of economic strength as witnessed by rising corporate profitability.

Therefore, stocks are the only investment worth having.

My arguments are much more pragmatic.

First, it is worth noting that while the markets have risen to “all-time highs,” there was a massive amount of “time” lost in growing capital to meet retirement goals.

This is crucially important to understand as was something I addressed in “Stocks – The Great Wealth Equalizer:”

“By the time that most individuals achieve a point in life where incomes and savings rates are great enough to invest excess cash flows, they generally do not have 30 years left to reach their goal. This is why losing 5-7 years of time getting back to “even” is not a viable investment strategy.

The chart below is the inflation-return of $1000 invested in 1995 with $100 added monthly. The blue line represents the impact of the investment using simple dollar-cost averaging. The red line represents a “lump sum” approach. The lump-sum approach utilizes a simple weekly moving average crossover as a signal to either dollar cost average into a portfolio OR moves to cash. The impact of NOT DESTROYING investment capital by buying into a declining market is significant.”

“Importantly, I am not advocating “market timing” by any means. What I am suggesting is that if you are going to invest into the financial markets, arguably the single most complicated game on the planet, then you need to have some measure to protect your investment capital from significant losses.

While the detrimental effect of a bear market can be eventually be recovered, the time lost during that process can not. This is a point that is consistently missed by the ever bullish media parade chastising individuals for not having their money invested in the financial markets.”

However, setting aside that point for the moment, how valid is the argument the rise of asset prices is related to economic strength. Since companies ultimately derive their revenue from consumers buying their goods, products, and services, it is logical that throughout history stock price appreciation, over the long-term, has roughly equated to economic growth. However, unlike economic growth, asset prices are psychologically driven which leads to “boom and busts” over time. Looking at the current economic backdrop as compared to asset prices we find a very large disconnect.

Since Jan 1st of 2009, through the end of June, the stock market has risen by an astounding 130.51%. However, if we measure from the March 9, 2009 lows, the percentage gain explodes to more than 200%. With such a large gain in the financial markets we should see a commensurate indication of economic growth – right?

The reality is that after 3-massive Federal Reserve driven “Quantitative Easing” programs, a maturity extension program, bailouts of TARP, TGLP, TGLF, etc., HAMP, HARP, direct bailouts of Bear Stearns, AIG, GM, bank supports, etc., all of which total more than $33 Trillion, the economy grew by just $2.64 Trillion, or a whopping 16.7% since the beginning of 2009. The ROI equates to $12.50 of interventions for every $1 of economic growth.

Not a very good bargain.

Furthermore, the Fed’s monetary programs have inflated the excess reserves of the major banks by roughly 332% during the same period of time.  The increases in excess reserves, which the banks can borrow for effectively zero, have been funneled directly into risky assets in order to create returns.

With the Fed threatening to withdraw the reinvestment from their massive balance sheet, one has to ask just how much risk to asset prices there currently is?

Unfortunately, while Wall Street has benefited greatly from the Fed’s interventions, Main Street has not. Over the past few years, as asset prices surged higher, there has been very little translation into actual economic prosperity for a large majority of Americans. This is reflective of weak wage, economic and inflationary growth which has led to a surge in consumer debt to record levels.

Of course, weak economic growth has led to employment growth that is primarily a function of population growth. As I addressed just recently:

“The first is that the number of ‘real’ employees, while growing, is in lower income producing and temporary jobs, and the rate of job growth is substantially lower than the growth of the population.”

While reported unemployment is hitting historically low levels, there is a swelling mass of uncounted individuals that have either given up looking for work or are working multiple part time jobs. This can be clearly seen in the chart below which is the working age population of those between the ages of 16 and 54 as a percentage of that same age group. (This analysis strips out the argument of retiring baby boomers, who ironically, aren’t retiring, not because they don’t want to, but because they can’t afford to.)

These higher levels of under and unemployment have kept pressures on wages even as work hours have lengthened. The declines in real income are evident as the burgeoning “real” labor pool, and demand for higher wage work, is actually suppressing wages as companies opt for increasing productivity, continued outsourcing, and streamlining employment to protect corporate profit margins. However, as the cost of living is affected by the rising food, energy and health care prices without a compensatory increase in incomes – more families are forced to turn to assistance in order to survive.

Without government largesse, many individuals would literally be living on the street. The chart above shows all the government “welfare” programs and current levels to date. The black line represents the sum of the underlying sub-components.  While unemployment insurance has tapered off after its sharp rise post the financial crisis, social security, Medicaid, Veterans’ benefits and other social benefits have continued to rise.

Importantly, for the average person, these social benefits are critical to their survival as they make up more than 22% of real disposable personal incomes. With 1/5 of incomes dependent on government transfers, it is not surprising that the economy continues to struggle as recycled tax dollars used for consumption purposes have virtually no impact on the overall economy.

It is extremely hard to create stronger, organic, economic growth when the dependency on recycled tax-dollars to meet living requirements remains so high.

But, Earnings Have Beaten Estimates?

Corporate profits have surged since the end of the last recession which has been touted as a definitive reason for higher stock prices. While I cannot argue the logic behind this case, as earnings per share are an important driver of markets over time, it is important to understand that the increase in profitability has not come strong increases in revenue at the top of the income statement.

The chart below shows the deviation between the widely touted OPERATING EARNINGS (earnings before all the “bad” stuff) versus REPORTED EARNINGS which is what all historical valuations are based on. I have also included revenue growth as well.

This is a not a new anomaly, but has been a consistent “meme” since the end of the financial crisis. As the chart below shows while earnings per share have risen by over 260% since the beginning of 2009 – revenue growth has barely eclipsed 30%.

As expected, since the economy is 70% driven by personal consumption, GDP growth and revenues have grown at roughly equivalent rates.

While suppressed wage growth, layoffs, cost-cutting, productivity increases, accounting gimmickry and stock buybacks have been the primary factors in surging profitability, these actions have little effect on revenue growth. The bigger problem for investors is all of the gimmicks to win the “beat the estimate game” are finite in nature. Eventually, real rates of revenue growth will matter. However, since consumer incomes have been cannibalized by suppressed wages and interest rates – there is nowhere left to generate further sales gains from in excess of population growth.

So, while the markets have surged to “all-time highs,” for the majority of Americans who have little, or no, vested interest in the financial markets their view is markedly different. While the Fed keeps promising with each passing year the economy will come roaring back to life, the reality has been that all the stimulus and financial support can’t put the broken financial transmission system back together again.

Eventually, the current disconnect between the economy and the markets will merge.

My bet is that such a convergence is not likely to be a pleasant one.

The Insecurity Of Social Security

According to the June 2017 snapshot from the Social Security Administration, nearly 61.5 million people were receiving a monthly benefit check, of which 68.2% were retired workers. Of these 41.9 million retirees, more than 60% count on their Social Security to be a primary source of income.

Of course, that dependency ratio is directly tied to financial insolvency of the vast majority of Americans.  According to a Legg Mason Investment Survey, US baby boomers have on average $263,000  saved in defined contribution plans. But that figure is less than half of the $658,000 they say they will need to retire. As noted by GoBankingRates, more than half of Americans will retire broke.

This is a huge problem that will not only impact boomers in retirement, but also the economy and the financial markets. It also demonstrates just how important Social Security is for current and future generations of seniors.

Of course, the problem is that according to the latest Social Security Board of Trustees report issued last month, those benefits could be slashed for current and future retirees by up to 23% in 2034 should Congress fail to act. Unfortunately, given the current partisan divide in Congress, who have been at war with each other since the financial crisis, there is seemingly little ability to reach any agreement on how to put Social Security on sound footing. This puts those “baby boomers,” 78 million Americans born between 1946 and 1964 who started retiring last year, at potential risk in their retirement years. 

While the Trustees report predicts that asset reserves could touch $3 trillion by 2022, implying the program is expected to remain cash flow positive through 2021, beginning in 2022, and each year thereafter through 2091, Social Security will be paying out more in benefits than it’s generating in revenue, resulting in a $12.5 trillion cash shortfall between 2034 and 2091. That is a problem that can’t be fixed without internal reforms to the pension fund due specifically to two factors: demographics and structural unemployment.

With respect to the demographic problem, it is a “one-two knock out punch” that will hit not only Social Security but also the country’s municipal and Federal pension systems. As I noted previously:

“One of the primary problems continues to be the decline in the ratio of workers per retiree as retirees are living longer (increasing the relative number of retirees), and lower birth rates (decreasing the relative number of workers.) However, this ‘support ratio’ is not only declining in the U.S. but also in much of the developed world. This is due to two demographic factors: increased life expectancy coupled with a fixed retirement age, and a decrease in the fertility rate.”

The structural shift in employment, due to the impact of technology and automation, is an overarching problem that few give little attention to.

While the mainstream media’s focuses their attention on the daily distribution of economic data points, there is a hidden economic depression running along the underbelly of the country. While reported unemployment is hitting historically low levels, there is a swelling mass of uncounted individuals that have either given up looking for work or are working multiple part time jobs. This can be clearly seen in the chart below which is the working age population of those between the ages of 16 and 54 as a percentage of that same age group. This strips out the argument of retiring baby boomers, who ironically, aren’t retiring not because they don’t want to, but because they can’t afford to.

These higher levels of under and unemployment have kept pressures on wages even as work hours have lengthened. The declines in real income are evident as the burgeoning “real” labor pool, and demand for higher wage work, is actually suppressing wages as companies opt for increasing productivity, continued outsourcing, and streamlining employment to protect corporate profit margins. However, as the cost of living is affected by the rising food, energy and health care prices without a compensatory increase in incomes – more families are forced to turn to assistance in order to survive.

Without government largesse, many individuals would literally be living on the street. The chart above shows all the government “welfare” programs and current levels to date. The black line represents the sum of the underlying sub-components.  While unemployment insurance has tapered off after its sharp rise post the financial crisis, social security, Medicaid, Veterans’ benefits and other social benefits have continued to rise.

Importantly, for the average person, these social benefits are critical to their survival as they make up more than 22% of real disposable personal incomes. With 1/5 of incomes dependent on government transfers, it is not surprising that the economy continues to struggle as recycled tax dollars used for consumption purposes have virtually no impact on the overall economy.

As millions of “baby boomers” approach retirement, more strain is put on the fabric of the welfare system. The exact timing of this crunch is less important than its inevitability.

There are two critical factors driving this inevitability. The first is that the number of “real” employees, while growing, is in lower income producing and temporary jobs, and the rate of job growth is substantially lower than the growth of the population. Since social security contributions are calculated as a percentage of income – lower income levels produce lower contributions.

The second factor, as shown above, is the ever larger share of personal incomes being made up of government benefits reduces social security contributions.

As stated above, the biggest problem for Social Security, and the U.S. in general, comes when Social Security begins paying out more in benefits than it receives in taxes. As the cash surplus is depleted, which is primarily government I.O.U.’s, Social Security will not be able to pay full benefits from its tax revenues alone. It will then need to consume ever-growing amounts of general revenue dollars to meet its obligations–money that now pays for everything from environmental programs to highway construction to defense. Eventually, either benefits will have to be slashed or the rest of the government will have to shrink to accommodate the “welfare state.” It is highly unlikely the latter will happen.

As millions of baby boomers begin to retire another problem emerges as well. Demographic trends are fairly easy to forecast and predict. Each year from now until 2025, we will see successive rounds of boomers reach the 62-year-old threshold. There is a twofold problem caused by these successive crops of boomers heading into retirement. The first is that each boomer has not produced enough children to replace themselves which leads to a decline in the number of taxpaying workers. It takes about 25 years to grow a new taxpayer. We can estimate, with surprising accuracy, how many people born in a particular year will live to reach retirement. The retirees of 2070 were all born in 2003, and we can see and count them today.

The second problem is the employment problem. The decline in economic prosperity, that we have discussed extensively, caused by excessive debt, reduction in savings, declining income growth due to productivity increases and the shift from a manufacturing to service based society will continue to lead to lower levels of taxable incomes in the future.

This employment conundrum is critical. Back in 1950, as the baby boom was just beginning to start, each retiree’s benefit was divided among 16 workers. Taxes could be kept low. Today, that number has dropped to 3-workers per retiree, and by 2025, it will reach–and remain at–about two workers per retiree. In other words, each married couple will have to pay, along with their own family’s expenses, Social Security retirement benefits for one retiree. In order to pay promised benefits, either taxes of some kind must rise or other government services must be cut. Back in 1966, each employee shouldered $555 dollars of social benefits. Today, each employee has to support roughly $18,000 of benefits. The trend is obviously unsustainable unless wages or employment begins to increase dramatically and based on current trends that seems highly unlikely.

The entire social support framework faces an inevitable conclusion where no amount of wishful thinking will change that outcome. The question is whether our elected leaders will start making the changes necessary sooner, while they can be done by choice, or later when they are forced upon us.