Washington Square Capital Management Blog

Retailers are in the business of parting consumers from their money and they have been remarkably successful at this over the past several years.  However, we believe this holiday season will turn out to be very tough for most retailers as consumers will continue to maintain tight control over their spending.  Consumer spending levels have been a concern since this recession started.  Most observers predicted consumer spending would fall since households entered this recession with very weak balance sheets, high debt levels and low savings.  Added to this weakness in household finances is the pace and extent of job losses, worse than any we have seen since 1983, with a real possibility that they may be worse than the early eighties.  Consumption usually falls when unemployment rises, because people spend less when they aren’t earning.  However, consumer spending has fallen further during this recession because of something called the wealth effect.  When people feel less wealthy, they tend to spend less.  And as home prices and investment valuations have fallen over the past couple of years, a lot of us (not just those unemployed) have begun to feel less wealthy, and as a result curtail spending.

A key portion of any recovery is the stabilization of consumer spending, and a crucial part of this spending occurs around the holidays.  With this in mind, we have been looking closely at expectations and trends for retail sales over the holiday season.

A recently released ARG/UBS survey polled consumers about their anticipated spending patterns this holiday season is very revealing.  They report that over 50% of survey respondents said they plan to spend less this holiday season on gifts, and most plan to buy fewer gifts for fewer people.  Even children know they have to limit their expectations for Christmas gifts.  ARG estimates sales will be down 2.9% when compared with 2008 (and those were down 2.7% over 2007).

We routinely look for unorthodox sources of economic data to complement traditional sources. One data source we’ve become interested in recently is Google Trends, which provides statistics on what people are searching for on Google.  The Google team has made a number of different “canned queries” available and their research team published a paper earlier in the year examining how Google trends could be used as a measure of activity.  What we found most intriguing were the luxury goods query statistics, which show a year over year decline of over 5%.  Since Google trends measures the proportion of total queries (i.e. it accounts for the fact that the total number of queries on Google is growing) it may simply be that interest in things other than luxury goods has risen, or that more people have found the best online stores and visit them directly.  However, we believe this data may augur poorly for luxury good sales this holiday season, and this view is reinforced by the ARG survey result that consumers are planning to trade down.

So, in our view the prognosis for retail sales this holiday season does not look good.  Where then does that leave us?  The chart below plots retail sales excluding-autos along the red line and retail sales and food services (a much broader measure) along the blue line.  We adjusted for inflation to produce these charts, the nominal numbers look worse since we had some deflation in 2008/2009.  The data is from the census.gov and bls.gov.

Retail sales are declining at a slower pace, but at -3.04% the rate of decline for September’s retail sales (ex autos) remains worse than any other seen over the past 15 years.  The remarkable story though, is in the level of sales, which we plot below.

In real terms, the broadest measure of consumption is in the same range as it was in 2000-2002.  Real retail sales excluding autos and food service are at 2004 levels.  These numbers look far worse on per capita terms since the US population is growing by 2.75 million a year.  What makes this picture even gloomier is that the current levels are being propped up by massive amounts of government support.  Unemployment benefit periods have been extended for the longer-term unemployed, and auto-sales have been propped up with incentives.  We shudder to think where consumption expenditure would be without these supports, yet at some point consumers and businesses will have to confront the reality that this government assistance cannot last indefinitely.

So where does this leave us?  We believe this will be another difficult holiday season for retailers, and the medium-term picture doesn’t look any better.  Consumers have cut back spending to real levels last seen 5-9 years ago, and there is no prospect of a quick rise to pre-recession consumption.  We see a slow, halting recovery over 5-7 years for the following reasons:

• Unemployment is likely to remain over 6% for 5-7 years,
• Chastened consumers are saving to repair their personal balance sheets and pay down debt
• Stimulus spending will have to be withdrawn eventually
• Federal and state deficits will have to be repaired and higher taxes will eat  into consumers discretionary income.

We now know that we had too many mortgage bankers, home construction workers, and investment bankers than natural growth could sustain.  It may well be true that we had too many retail stores and salespeople.  If retail sales do not recover for years, we will have to become accustomed to shuttered stores in many areas.  Many people formerly employed in retail trade will have to look to other industries for employment.  The big structural question confronting us is how US businesses are going to produce productive employment for these workers and resources.  This will require retraining, and it may require the movement of labor across geographies.   It will definitely take time.

The extent of the market’s shrinkage in 1969-70 should have served to dispel an illusion that had been gaining ground during the past two decades.  This was that leading common stocks could be bought at any time and at any price, with the assurance not only of ultimate profit but also that any intervening loss would soon be recouped by a renewed advance of the market to new high levels.  That was too good to be true.  At long last the stock market has “returned to normal,” in the sense that both speculators and stock investors must again be prepared to experience significant and perhaps protracted falls as well as rises in the value of their holdings.  – Ben Graham in “The Intelligent Investor”

For years, investors have been told there is an easy, simple way to invest, requiring very little effort, by using index funds.  Many amongst us have been seduced into believing that we can safely invest in stocks, or stay invested, as long as we have a long enough time horizon.  This claim is generally based on analyzing the unique market trajectory of the United States, where stocks have outperformed other investments over most long-time periods (20 to 30 years).  Of course, over shorter periods (say 5 or 10 years), returns from stocks have been painfully small or even negative, and as Keynes said: “In the long run, we’re all dead.”

In addition to being told that stocks are the best game in town, investors are relentlessly advised to buy large numbers of stocks, via index funds.  Too many have taken this easy way out and bought stocks without any sound analysis and we fear the market has begun to reflect this laziness.

I have a parable for you, or perhaps a fable.  Imagine market participants as a herd of buffalo on the plain.  The herd moves together, often quickly.  In the past, it has never run off a cliff because enough buffalo are looking around for the tell-tale signs of a drop-off and slow it down.  One morning, a buffalo has the bright idea that since the herd has never run off a cliff (at least not in living memory, or as far back as the data is readily available), it would make sense to simply follow the herd and stop looking for signs of cliff-edges.  Once enough buffalo buy into this strategy and become free-riders, the herd itself becomes less aware.  As a result, the herd has fewer and fewer buffalo actively participating in picking direction, alert individuals get pushed into the center of the herd, effectively blinding them.  This blind herd runs willy-nilly all over the plain, and eventually it will run off a cliff.

Sometimes it makes sense to cut oneself out of the herd in the interest of self-preservation and go your own way, so you can see clearly.

I’d be a bum on the street with a tin cup if the markets were always efficient.  — Warren Buffet

We wrote earlier this year about the debate surrounding the Efficient Market Hypothesis (EMH).  The EMH, roughly speaking, claims all relevant information that is presently known is incorporated into market prices.  For some time now, we’ve viewed the EMH with some skepticism.  Two recent editorials, one by Jeremy Siegel in the WSJ, and the other by Martin Wolf in the FT, prompted us to revisit the subject and reiterate our skepticism about the EMH.  We think part of the reason these two camps disagree is that they are not trying to answer the same question.

The EMH camp asks the question “what are stocks going to do tomorrow”, and says (with some justification) that it is difficult to predict tomorrow’s moves because the sum total of all market-moving “information” is reflected in the price.   In our view, this is not a particularly insightful observation, partly because the question itself is largely irrelevant for an investor (as opposed to a trader).

The Value camp (Ben Graham, Warren Buffet, Jeremy Grantham) believe the right question for an investor to ask is “should we buy stocks today”, or “if we buy stocks today, do we stand a reasonably good chance of achieving an acceptable return”.  We believe this is a far more crucial question.  The value camp has developed numerous mechanisms to measure the value and risk of an investment based on expected returns.

By convincing many investors that “the market is always right” and that evaluating investment opportunities for themselves is not worthwhile, the EMH camp has successfully encouraged many market participants to become lazy.  And if these multitudes ARE the market now, the market itself has stopped evaluating investments on their merits.  This is how markets get to be wrong and their self-correcting nature is undermined.

A public-opinion poll is no substitute for thought. — Warren Buffet

In his article, Siegel says the fault for the bubble is not with the EMH, but with market participants (ratings agencies and investors) who failed to do their homework on their investments.  That’s pretty rich coming from someone who has been telling investors that doing homework is futile because the market already incorporates all known information.  The folks who buy into this notion have stopped looking for information and see no value in doing their own analysis.  I am not suggesting that Mr. Siegel and his friends in the EMH camp were the first to promote laziness amongst investors and unknowingly encourage the markets to run off cliffs.  Many others before them have touted the same tactics, see the quote from Graham we started with.  We’re also certain this won’t be the last attempt to lull investors into believing easy gains are possible from investing in stocks, or houses, or any other asset for that matter.  As we’ve seen over the past year, this is the stuff of which tragedies are made.