Reading The Tea Leaves

I warn you right away that this post is a bit complicated - arithmetically. I hope it won't bore you if you stick with it...

In the previous post (Bubble Implosion) I presented the possibility of a drop in household assets by $22-25 trillion (in 2006 dollars) when the asset/debt bubble collapses. In today's post I will examine in more detail the various assets held by households to see which assets may decline and by how much.

The chart below details US household assets by type (data from the Federal Reserve).

"RE" stands for Real Estate, "Pensions" refers to assets held by private and public pension funds (Social Security not included), "Stocks and MF" are stocks and Mutual Funds held directly by households and "Business Equity" is the equity value of non-incorporated small businesses; the rest are self-explanatory. Note that pension assets are almost 80% invested in stocks, bringing the total direct and indirect household ownership of stocks to $19 trillion.

The total equity and real estate assets of households come to $47 trillion. It will be there that the $22-25 trillion decline will occur. In gross terms, the combined value of real estate, stocks and small businesses will have to decline by some 45-53% to wash out the excess that has been built up over the past 20 years. We need to refine this further:

1. It is unlikely that house prices will drop by 50% - people need a roof over their heads. They will preferentially liquidate financial assets to service mortgages before they give up their homes. Let's pick 35% as the percentage drop for real estate, or $7 trillion.
   
2. Small businesspeople will also try to hang on to their shops, etc. as a way to make a living; let's also pick 35% as the drop for small business value, or $2.5 trillion.
   
3. So far we have accounted for $7+2.5 = $9.5 trillion out of a total $22-25 trillion drop expected. This means that $12.5-15.5 trillion will be wiped out from stocks. Let's pick the lower value, just to be on the "conservative" side.
   

US household stock assets include holdings in foreign stocks - approximately 20% of total. Therefore, out of the $12.5 trillion decline the domestic portion is $10 trillion. Since the total market capitalization of US equities is currently $17 trillion, this implies an ultimate drop of 59% from current levels for US stocks.

This implies a projection for the various popular stock indexes...The levels below are in 2006 equivalent dollars and won't/can't happen immediately. It will be a long decline lasting several years as assets lose value in step with debt liquidation. If I had to guess, the whole process will take at least five years and more likely ten. Note that this is not a prediction based on technicals, super-cycles, Elliot waves, Gann angles and such arcana. It is a top-down fundamental macroeconomic projection based on restoring US asset/debt ratios to more sustainable levels and will be affected by the ultimate asset/debt ratio and the relative performance of other asset classes (i.e. real estate, bonds, etc). Still, the levels below are useful as signposts...

THE BOTTOM LINE

DJIA: ~5,100-6,100
S&P 500: ~580-700

A warning (needless, I hope): Macro-economics is known as the dismal science; it is equal parts science and the equivalent of goat-bone reading. Not only are data grossly and routinely massaged to fit given perceptions of reality (eg seasonality, hedonic pricing, etc), but proper interpretation is always a challenge. Example: the inventory to sales ratio has been dropping for years. Does that mean that businesses are depleting stock and will shortly increase orders? Or does it mean that just-in-time transportation systems and technology have permanently altered logistics? So...be wary of Oracles.

In the next post I will attempt to create a projected time perspective for the above Bubble Implosion process. In the meantime, have a:

HAPPY AND HEALTHY NEW YEAR