The Inoculated Investor http://inoculatedinvestor.blogspot.

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Putting to Rest the Myths about Consumption

It’s Labor Day Weekend. What are you doing sitting at home? Go out and spend! There are endless numbers of sales
going on at your favorite retailers. Forget that your credit card is maxed out, you are late on your utility payments
and that you are trying to get the bank to reduce the face amount of your mortgage. If you don’t leave the house to
buy things and eat fancy dinners there is no way the US is going to recover from this recession. It is your duty as an
American to help us spend our way out of the current economic malaise, irrespective of the additional debt you are
forced to take on to achieve this universally desirable goal. The idea that people should save their money and live
within their means only applies to those countries over there in Asia. Americans are innovative and resilient. We are
not going to let something as trivial as an excessive amount of debt (that must eventually be paid back) get in the
way of living the life we have always dreamed of. Please, take your cues from the US government and borrow and
spend more so we can get back on the path towards limitless prosperity. Don’t worry about those who say we cannot
consume our way out of a debt-induced crisis. They are either un-American or are just jealous of our position in the
world.

Forgive the hyperbole but this is disturbingly similar to the message being sent to the American public by both the
corporations that rely on consumer spending to reward shareholders and pay huge bonuses and the government that
seems to think that if we can just go back to 2006 everything will be fine. I think the widely popular Cash for
Clunkers initiative embodies perfectly the sentiment espoused above. Have a car that is already paid off but think
you could use a shiny new ride? The US government can help. In exchange for your old jalopy and a car note that
only increases your debt burden, the government will subsidize your desire to drive around in style. And guess
what? A wonderful side effect is that your purchase will help the struggling automakers that the US government now
owns. It’s a win-win for everyone. Well, except for maybe your balance sheet that now is even more strained.

It was with all of this in mind that I came across a posting on Zero Hedge with commentary from the chief
economist at Saxo Bank. An idea that I don’t think gets anywhere near as much attention as it should is the one
whose premise is that the US consumer has basically hit a debt wall.

To me, it looks like the consumers have finally hit the wall where there is essentially no pent-up demand
left. After decades of systematic and constant demand stimulation via artificially low interest rates and the
emergence of the “demand driven economy” (as if there ever was any such thing!), we have succeeded in
borrowing so much from future demand that our present GDP has been overstated by 10-30%. How many
resources have been put to use in order to make American consumers push their excessive debt-financed
consumption to new highs? How many malls, shopping centers, financial intermediaries, debt extension
companies and SUV dealers have been set up for which there is no long-term use? And by how much has
that overstated prior GDP figures, since these types of companies were mal-investments and need to be
written off?

In my eyes, it wasn’t the subprime housing market that caused the crisis; that collapse was just a symptom of the
consumer no longer being able to service his/her debt. In other words, this was a balance sheet and solvency crisis
from the beginning. Yes, maybe that caused a liquidity freeze but that was also just a symptom. I think when
historians look back on this period they will easily conclude that the Anglo Saxon world accumulated so much debt
that one day that burden became unsustainable and caused a necessary but painful unwind of the economy. I also
think they will look at government initiatives that pulled forward demand and induced irrational spending (such as
Cash for Clunkers) kind of the way we look at the economists of influence in the 1930s. They will ask without any
lack of condescension: “What in the world were they thinking?” Instead of a debt crisis our current leaders saw a
liquidity freeze. Instead of encouraging frugality and debt repayment (however painful that would have been in the
short run) they expected people to consume in order to prop up a failed economic system that was far too dependent
on frivolous spending.

Has it occurred to anyone else but me that we take the fact that 70% of US GDP is based on consumption as if that
number were ordained by God? Seriously, that percentage is quoted so much you almost start to believe that it is
etched in stone or is the secret code that leads to sustainable prosperity. What if it really means our economy was
incredibly imbalanced? What if it means that Obama’s attempts to make us spend more are actually making things
much worse? No company ever fixed its over-levered balance sheet by engaging in even more debt fueled spending.
So, how is that the US consumer is going to achieve this miracle? From the piece by Saxo Bank:
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

The Keynesians never get tired of telling us that 70% of GDP is consumption. This is obviously a
misleading statement as if we can consume ourselves rich. If we want growth in the Western economies,
this percentage has to come down and investment and savings should be higher. This is the only long-term
solution to the extreme difficulties that we are confronted with. Only by growing our capital base will we
be able to increase production and growth. It is time we learn from the Chinese or simply look in the
history books and be inspired from how the economy of our ancestors could grow even though they didn’t
consume 70% of their income immediately. (Emphasis mine)

The future economy of the Western countries will be investment-driven if driven at all. Unfortunately, it
also means that the companies that are most dependent on consumption will be underperforming in the
years to come. Demand is permanently impaired and will not come back to 2007 levels soon.

What this implies is that the underlying demand for consumption that existed during the boom years may be reduced
or limited for a long time as people repair their balance sheets. As I continue to stress, the US has an incredible
amount of excess capacity of businesses that depend on an unsustainable amount of spending. We built too many
malls, too many restaurants, too many drug stores, and made the conscious decision that convenience trumped
economic realities. Why else would there be a drug store, bank, nail shop, and convenience store on every single
major intersection of every city and town in the US? These amenities were built to cater to peak demand (that may
never be revisited) and were based on the idea that supply and demand did not matter because the consumer was
always willing to spend for proximity and convenience. Now these ideas are being turned on their heads as people
are forced to spend less, eat at home more often, eliminate discretionary purchases and go out of their way to save
money. This is a particularly toxic combination of incentives from the perspective of those companies that relied on
a complete lack of fiscal restraint in order to prosper.

Based on all of this, what can we conclude about the potential impact on stocks of this excess capacity and reduced
consumption? Well, it can’t be good for restaurants that need people to eat out as opposed to cooking at home or for
retailers that offer goods whose purchase can be foregone without much of a detriment to an individual’s lifestyle.
Powershares Dynamic Leisure and Entertainment (PEJ) is an ETF that holds stocks such as Carnival Corp (CCL),
Darden Restaurants (DRI), Cheesecake Factory (CAKE) and Starbucks (SBUX). From a low of $6.15 in November
2008 this ETF has just about doubled and trades around $12. Call me naïve, but based on the evidence of an
increasing and perhaps prolonged consumer retrenchment, the recent appreciation of this stock seems a bit out of
line with the fundamental realities. Or how about Powershares Dynamic Consumer Discretionary (PEZ)? Betting on
companies such as Ralph Lauren (RL), Bed Bath and Beyond (BBBY) and Gap (GPS), this ETF has rallied from a
low of $11.79 in March and now trades at more than $18. This is despite the fact that retail sales numbers continue
to be absolutely terrible and the number of analysts voicing concerns about the upcoming holiday shopping season is
a bit startling.

Therefore, for investors looking to profit from the consumer being increasingly tapped out, there are a number of
options. Here are a few that make sense but of course involve the risk of the thesis being wrong or for the market to
remain exuberant and disconnected from the fundamentals for longer than anticipated. Keep in mind these are just
some suggestions presented in order to stimulate further thought.

1. SZK is the Proshares Ultra Short Consumer goods inverse ETF. It is levered in that it seeks “daily
investment results, before fees and expenses, which correspond to twice the inverse of the daily
performance of the Dow Jones U.S. Consumer Goods index.” The problems with levered ETFs are well
documented so beware of the possibility that the returns will not track twice the inverse of the index over
longer periods of time. Having said that, from a high of over $125 in November 2008 the stock is trading
not much above its 52 week low of $51. This ETF has been a casualty of the recovery trade and if an when
the recovery peters out, this one could explode to the upside.

2. For investors who are inclined to short individual stocks, I would look for companies that offer products
that are very discretionary in that cash-strapped and over-levered people can live easily without their goods.
Specifically, a company such as Pool Corp (POOL) that has more than doubled off of its 52 week low could
be compelling on the short side. I know the company derives a good deal of revenue from sales of pool
maintenance supplies but it is easy to imagine homeowners and builders not installing many new pools for
years to come and cutting back on maintenance expenses. Or what about ATV and snowmobile supplier
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

Polaris (PII)? The stock has rallied to almost $38 from its 52 week low of about $14.50 in March of this
year. It’s tough to believe that there is a whole lot of consistent demand for off road vehicles that are often
used for enjoyment as much as utility. Obviously, more research would be required in order to short either
of these companies. I am just using them as examples of businesses that I see as constantly battling to
overcome an increasingly more frugal and cautious consumer.

3. Finally, investors can look for companies that will benefit within an environment in which people are
looking to save money. Two of my favorite companies that fit this description are Jack in the Box (JACK)
and Safeway (SWY). Neither of these solid companies with very stable balance sheets has participated very
much in this rally. Both are still way off of their 52 week highs despite the fact that they have much more
resilient business models than the companies whose stocks have run up so much recently. JACK has one of
the best value menus of all of the fast food restaurants, is in the middle of a prudent re-franchising initiative
and owns the fast growing Qdoba concept. SWY offers one of the best private label assortments of products
of all of the large food retailers and will benefit from the very promising Blackhawk gift card subsidiary.
Even better, according to CAP IQ, both trade at under 10x trailing 12 month earnings per share. Given that
valuation, it is hard to imagine a scenario in which these companies that should see additional demand for
their moderately priced products (or at very least just hold up better) will not prosper even in sour
economic conditions.

(Picture of the debt wall courtesy of rooseveltinstitution.org)

(Disclosure: No Positions)