The consumer is dead… Long live the consumer!
We’ve faced some very bipolar news on the US consumer over the last two years. With the unprecedented turmoil in the markets, a real estate market that remains depressed and illiquid, unemployment stubbornly high, and shaky financial ground to begin with – most analysts (myself included) completely discounted the consumer’s ability to spend.
Since consumer spending is known to account for roughly 70% of GDP, this has not been good news.
But with all the headwinds, and with all the negative publicity… the consumer, it appears, is beginning to step up to the plate and once again spend us into recovery.
It should be considered good news, I guess. After all, numbers don’t lie and the statistics point to a relatively strong consumer with money in his pockets (or maybe plastic) and a list of wants akin to a seven-year-old at Christmas.
The strength is wide across the retail sector. Apparel stocks like Lululemon Athletica (LULU) and relatively new IPO Rue 21 Inc. (RUE) are only slightly off their all-time highs. Restaurants like growth stocks Chipotle Mexican Grill Inc. (CMG) and luxury Morton’s Restaurant Group Inc. (MRT) have staged impressive investment gains. Retailers from budget conscious Family Dollar Stores (FDO) to high-roller Tiffany & Co. (TIF) are all trading as if the consumer is healthy and spending once again.
And despite my reservations on this sector, I imagine that retail same-store-sales which will be reported on Thursday will show at least a stable pickup in consumer spending.
Where is the Money Coming From?
It’s been quite a mystery to me for some time now. Exactly where is all this pocket change coming from – especially considering the difficulties we are seeing in other areas (savings rates are once again headed lower, consumer credit hasn’t expanded by any material amount, and despite positive payroll headlines, the underlying report is full of holes).
It wasn’t until this past week when a colleague mentioned the term strategic default did I realize what was likely occurring. Many consumers are spending their mortgage payments! It’s beginning to make sense in the most disturbing way. As homeowners face staggering payments on houses that have negative equity, a large number are simply deciding not to pay their mortgage bill, resigned to the fact that eventually they will lose their house.
And what happens with the money that would have been sent to the lenders? Well, an increasing mentality of “eat drink and be merry – for tomorrow we’re evicted” has set in.
It didn’t used to be this way. For decades, the US consumer placed priority on home ownership. We might miss a credit card payment, and we might put off that family vacation, but we were NOT going to default on our mortgage. After all, home ownership was a privilege, and a serious wealth-building opportunity. Heck, even today there are plenty of retired Americans who are living solely on the equity they built in their homes over a number of decades.
But a sense of hopelessness has emerged when it comes to residential real estate. The principal of home ownership as a tool for wealth building is being sharply disputed. As adjustable mortgages reset to higher rates and payments become more difficult to make, we are likely to see even more homeowners throw up their hands in disgust. If home prices are likely to be low for years (if not decades) then why sacrifice to pay the mortgage on a home where the mortgage is much higher than the value?
Many consumers are willing to turn in the keys and walk – hoping maybe to get into a better deal once their credit is repaired.
On top of the negative equity issue, restrictions meant to help consumers are actually reinforcing this idea of strategic default. The past and current administration have both made it a priority to keep homeowners from being foreclosed upon whenever possible. Lenders are required to go through a series of bureaucratic steps before enforcing a foreclosure and many times this process takes several months to over a year to execute.
The good news is that homeowners who are truly struggling will be allowed to re-negotiate rates, possibly receive a write down on their principal owed, and participate in other federal and state programs aimed at giving them assistance.
But the dark side of this process is that many homeowners are purposefully not paying the mortgage in a strategic decision to allow the foreclosure process to happen and in the meantime to enjoy having the extra spending money. It is estimated that for every foreclosure on the market right now, there are five or six homes in strategic default.
How Long Can This Last?
The additional measures aimed at keeping homeowners in their houses and encouraging banks to write down loans may very well continue this process for some time. As with many other “moral hazard” issues, the intentions of regulators may be noble, but allowing a broad portion of the population (whether they be financial institutions or individual consumers) to escape without taking responsibilities for their actions will inevitably cause irresponsible behavior.
It would not surprise me to see several more months (if not a few more quarters) of strong consumer spending in part due to strategic default capital. Also as the market climbs higher and employment statistics are spun to be perceived as positive, more healthy consumers will likely open their purse strings and begin to increase spending.
The momentum may very well continue and that is why the ZachStocks Newsletter portfolio actually holds a long position in Green Mountain Coffee Roasters (GMCR). It may surprise readers to see a long position in this name because I have been vocal about my expectation for the stock to decline. I still believe that at the end of the year GMCR will be significantly lower, but with the current investor capital flowing toward speculative retail issues, we are taking a short-term trade as the stock breaks to new highs.
Unfortunately, while the situation looks sanguine on the surface, the longer we inflate this speculative bubble, the more disturbing it will be when the situation begins to unravel. I expect regional banks and holders of mortgage debt to be the first firms hurt as strategic defaults cause them to write down the value of loans.
Foreclosing on mortgages and auctioning off these properties is an expensive process and banks are likely to take significant losses at some point this summer or fall. As strategic defaulters are finally evicted from houses and must pony up rent money, the growth in consumer spending will likely kick in. At this point many speculative retail stocks will become excellent short opportunities.
The timing is difficult to nail down. For now, speculation is being rewarded and irresponsible behavior has led to a better lifestyle for many consumers. Retail traders are likely to be rewarded by either taking a short-term positive positions or sitting on the sidelines. Once this bubble bursts we will be active on the short side, but until that happens it makes little sense to step in front of the strong positive momentum in speculative retail stocks.
FD: Author has long positions in the ZachStocks Newsletter portfolio
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April 5th, 2010 at 9:41 am
Another reason for the uptick in consumerism would be a further fall of confidence in the dollar. The USD has fallen about 15% as compared to other fiat currencies. Yet the dollar has declined about 35% relative to gold during the same time frame.
Along with the return of the consumer, the savings rate has leveled off and is now lowering. This could reflect a change in the attitude of the saver as being one of pessimism towards the dollar. Spend now while the dollar still has some value versus hanging onto it and watching it’s purchasing power disappear.
April 5th, 2010 at 9:41 am
I believe the average “consumer” is clueless about the weakening dollar unless (s)he travels outside the US. We are constantly prodded to spend now while while the goods are on sale (which is every day). See the good little consumer hampsters spend, spend, spend. Recovering economy? Sure why not. Let’s go buy something to celebrate.
April 5th, 2010 at 9:43 am
In addition to strategic defaults, spending from black market activities would boost spending but would not be seen in incomes………just as strategic defaults. With the savings rate haven fallen to 3% and incomes stagnating, there’s not much to drive consumer spending going forward unless there will be a batch of strategic defaults as ARM and AltA mortgages reset over the next two years.
April 5th, 2010 at 9:44 am
Great article. One comment is worth repeating: “These strategic defaults are the people’s bailout and ends up being a massive stealth stimulus.” I’ll add it’s also a stealth expansion of the money supply. The money is flowing from the bailed-out banks to not only the defaulted owners, but also to the intermediaries who are now making a killing on under-priced foreclosure sales (same-day flips have been seen, but probably won’t hit the mainstream media for months). Did the Fed see this coming? If not, well, we’ve finally found a credible reason for inflation to pick up!
April 5th, 2010 at 9:44 am
AlexR – Many of these CRE loans came with a line-of-credit also, what is occuring is a ‘double whammy’. When the CRE loan is in trouble, the banks are finding that their line-of-credit is being completely drawn down to service the loan, before defaulting or turning the asset over to the loan vendor. Therefore leaving a gaping hole in their balance sheet. CRE loan + line-of-credit default.
Many smaller regional banks are at risk because of their over-exposure to the CRE/C&D markets. More bank failures to come.
April 5th, 2010 at 9:45 am
First you have to look for some truth in the statistics because while the gov’t reports retail sales increasing (ignoring real inflation) sales tax revenues keep going down so the gov’t stats are very suspect.
The author has accounted for much of the money suddenly available to stimulate the consumer. Add in a feeling of live high on the hog now because doom is coming also seems to prevail. Just as people live high on the hog just before filing BK, most consumers are seeing the handwriting on the wall for the economy and the country so enjoying it while they can.
There is no penalty for walking away from debts and undervalued assets so why is anyone paying debts or taxes today?
April 5th, 2010 at 9:46 am
I doubt very much that people are spending their mortgage payment money on discretionary or self-indulgent items. Planning a strategic default means you are also smart enough to know you better stash a nest egg for the 1st, last, and security on your new rental property… at least 3 months of your mortgage payments, plus moving costs which can amount to another 2 or 3 months of mortgage money. Anyone facing foreclosure is also facing bankruptcy or else the mortgage company is coming back at them for the post-auction lose relative to the original mortgage value. So you must expect to save for legal fees too.
And expecting strength in a few retail stock prices to be caused by improving consumer spending is another illusion. Stock prices are the “anticipation” of future earnings. Right now we have lots of money sitting on the sidelines, desperate to recover losses from the past 2 years. That money will be chasing all kinds of investments, driving up prices on speculation alone.
I do think that strategic defaults are the consumers portion of the bank bail-out money and as more underwater consumers realize it is their only way to recover from real estate losses, foreclosures will continue to grow.
I think people are buying only what they have to. Hopefully that is enough to keep our stagnated economy going, but we still have a lot of hard hurdles ahead. Of course, companies will out-compete one another but I’m not looking for aggregate revenues or consumer spending to grow in any industry. The notable exception is energy and food commodities, we are going to pay through the nose for those.
April 5th, 2010 at 9:46 am
I kinda agree, that consumers planning strategic defaults would be kinda stupid to go shopping….the article has an element of truth to it but probably not all strength in consmer is due to strat defaults.
But if treasury and BAC are going to write off the portion of ones mortgage above the market vaue of the property then this could be the writedown that ends it all…resulting i a real stimilus.
April 5th, 2010 at 9:47 am
I live in one of the least affected states, Texas, and I personally know people who are doing exactly this. One girl I know (good paying job and recently divorced) hasn’t made a payment in a year while working on a modification. She now spends most of her time buying $1,200 purses for only $800 on Ebay….. “But it was too good a deal to pass up”………. I kid you not!!
She has always spent extravagantly and continues to do so. I think people have learned how to game the system too well.
I too wondered if these types of people are holding up consumer spending. I believe you are correct. Nice article!!
April 5th, 2010 at 9:49 am
There is definitely some truth to the argument, however a bigger factor is the state of panic people were in a year ago. YOY comparisons are silly to hold in high regard and numbers are not impressive compared to per capita spending in 2007 and prior. Addicted consumers are simply leveraging themselves on smaller budgets, this uptick is not a sustainable trend.
April 7th, 2010 at 1:31 pm
Jeff – I think you are taking that statement a bit out of context – I’ve never been one to rely solely on the government numbers – but you can’t deny most retailers have been reporting strong sales increases – and this is true not just for luxury spending but regular mom and pop stores – from basic essentials all the way to purely discretional items – you HAVE to account for these increases even if you throw the government numbers out the window.
AlexR – You make a great point – strategic defaults really ARE a stealth stimulus, and the bill is unfortunately paid by the taxpayers and by true paying homeowners who will see the value of their properties further decimated by the eventual foreclosures that MUST happen.
Donald – I agree with you in principal on the regional banks – but do you have some short opportunities in particular? Would love to see some tickers you’re watching.
Will DiJohn – you state that “anyone facing foreclosure is also facing bankruptcy” and you are right. So why would ANYONE in their right mind pile up cash that will be frozen and taken away during the bankruptcy process?
Atareen – you’re right – same song, second verse. I think it was
PTJ who said that the real tragedy of this crisis is that we haven’t learned a thing – in fact we’ve learned the WRONG lessons. The lesson consumers have picked up is that if you act irresponsibly enough, someone will come behind you and help you out.
Thanks for the comments guys!
zachstocks.com
April 13th, 2010 at 10:35 am
Zach, your comment “anyone facing foreclosure is also facing bankruptcy”, (therefore won’t pile up cash). I thought mortgages were ‘non-recourse’ loans, so while defaulters will destroy their credit, they won’t be facing personal bankruptcy, therefore can keep the upaid mortgage cash?
April 13th, 2010 at 2:57 pm
While mortgage contracts can take on many different nuances, my understanding is that the majority of mortgages are not “non-recourse” meaning the bank actually can come after other personal assets. The homeowner may or may not declare bankruptcy, but more often than not, the lender would have a legitimate claim on cash in a bank account.
April 13th, 2010 at 3:28 pm
Zach, thanks, then re your eventual retail short thesis: There are approx 7 million mortgages seriously delinguent. It seems many are using the unpaid premiums to shop and plan to have little cash other than their 3 month deposit when they are forced to rent (in which case banks won’t waste legal fees/time on legal persuit). You need a lot of insight on the likely timing of these foreclosures to judge the downturn of this huge unintentional ‘bank financed’ retail stimulus program. Since there will be rolling waves, ARM trigged start dates etc, it’s a complex equation. I suspect this may unfold more slowly than expected, propping up retail longer than seems reasonable.
How do you model this complex, parallel series of dynamics in deciding when to eventually short retail?
April 13th, 2010 at 4:48 pm
Hey Alan,
Rather than modeling a complex formula (which often can lead to a false sense of clarity – and would likely be fairly unreliable – remember, we’re dealing with human nature here…) I prefer to look at retail from a couple of different vantage points.
First – The current trade is UP. Fundamentals are supported by default spending and speculative trading is driving equity multiples higher. So to step in and short now would be dangerous – in fact, there are some great short-term LONG trades setting up.
Second – RISK is very high… If the strength in retail is built on the unsustainable practice of strategic defaults, then eventually the bubble will burst and prices will come down – timing is difficult to determine but long-term investors should hold retail positions in an open hand and consider decreasing exposure on this strength.
Third – Charts will be an invaluable tool for determining the timing for the ultimate decline. I’m expecting to see some of the most speculative names stage breakouts that quickly fail, for moving averages of retail ETFs to be violated, and then after the first few signs of failure, the entire industry could come under pressure.
It may sound “off the cuff” but I would rather put out some small “feeler” trades in a few select short names and then build into more size once the full retreat is underway. Not a sophisticated model, but a carefully crafted – risk managed way of approaching the situation.
Thanks for the comments!
Zach