The Age of Deleveraging

A. Gary Shilling, “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation” John Wiley & Sons, 2011, 497 pps

A must read book for investors—a book which truly makes you reevaluate investment beliefs formed during the past long bull market as well as from most financial advisors. Contrary to most investment advisers, Shilling convincingly maintains that the global economy has begun a decade-long period of de-leveraging. This decade of weak growth will perpetuate a struggle for the U.S. and world economy and, as Japan has shown, these are difficult conditions to offset with monetary and fiscal policies. We can expect 8 to 9 percent unemployment levels to persist and annual declines in general price indices of 2 to 3 percent. Also, investors must become aware that the strategies that have worked for the last 25 years will not work for the next 10—furthermore, total returns on the U.S. stock market, at best, will average 2 to 3 percent over the next decade, with essentially all of it coming from dividend yields. If deflation occurs as predicted, you can add another 2 to 3 percent real return.

Shilling has been consistently correct about major economic trends since he began forecasting in the early 1980s and he now advises investors to avoid broad exposure to stocks, real estate, and commodities and to focus on high-quality bonds, high-dividend stocks, and consumer staples and food stocks. (He began forecasting the impending housing collapse in 2002).
My Notes:

Pg. 54: The brief federal government surplus in the late 1990s was the result of the stock bubble and the robust economy it spawned. Tax revenues from realized capital gains, exercised stock options, and leaping incomes were responsible, so the surplus faded with the onset of the bear market (dot com bust). Then followed the recession, massive tax rebates and cuts, and spending jumps for homeland security and the Afghanistan and Iraq wars.

Pg. 109: As taxpayers own incomes and assets are under stress, they may demand cuts in state and local employee compensation since wages exceed those in the private sector by 34 percent on average and benefits are 70 percent more expensive. (The author does not cite a source).

Pg. 133: Major U.S. investment banks’ combined assets jumped from under $2 trillion in 2003 to over $4 trillion in late 2007, and their leverage ratios rose by 50 percent in that time.

Pg. 134: Because of government regulation of securities markets in reaction to the Depression, a much more active Fed, the FDIC, and the bailout of Lockheed in 1971, Chrysler in 1979, the savings and loans in the early 1990s, the airlines after 9/11, and so forth, players today have come to expect government help in times of financial crisis and, therefore, take great risks. Also, senior officials are managers, not the owners of firms and get big payoffs even for failure.

Pg. 178: For the next decade, Shilling is forecasting an average one percentage point increase in the saving rate annually, rising to more than 10 percent in 10 years. At that point, it still may not exceed the 12 percent saving rate of the early 1980s. And even a decade of vigorous saving will probably not return household net worth even close to its former peaks.
Pg. 262: In 1973, 24.5 percent of private-sector workers were unionized, but in 2009 it was only 7.2 percent. In contrast, government unionized jobs have grown from 24.1 percent in 1973 to 37.4 percent of government jobs in 2009.

Pg. 274: People do not realize that inflation is a wartime phenomenon. In peacetime, deflation rules. In the 92 war years since 1749, including shooting wars, the Cold War, the War on Poverty, and the recent War on Terror, wholesale prices rose 5.77 percent per year, on average. In the 168 years of peace, they fell an average 1.16 percent annually. Starting in 1941, the nation suffered a uniquely long era of mostly war years. Fueled by excess government spending on Vietnam and Great Society programs, inflation rates began to rise in the late 1960s. By 1980, with double-digit rates prevailing, most forecasters believed high inflation would last forever. The global economy will continue to produce at levels exceeding demand, that creates deflation which will continue to reign until another war or similar event occurs.

Pg. 297: Estimates are that between 2000 and 2006, 65 percent of the jobs lost in manufacturing were due to productivity growth, with only 35 percent due to outsourcing overseas. Not only new technology but also a seasoned labor force should continue to hype productivity in future years.

Pg. 351: Just as it took the sobering 1930s to put the Great Gatsby opulence of the 1920s in perspective, today—with two breathtaking stock declines, the housing collapse, and severe financial crises—we are beginning to appreciate the exuberance of the 1980s and 1990s. And we still have to deal with the possible demise of the euro, and brewing major problems in China and Japan. Stocks are still not cheap, despite all this turmoil. Shilling predicts that total returns on the U.S. stock market, at best, will average 2 to 3 percent over the next decade, with essentially all of it coming from dividend yields.

Pg. 364
Investments to sell or avoid are:
• Big-ticket consumer purchases.
• Credit card and other consumer lenders.
• Conventional home builders and suppliers.
• Antiques, art, and other tangibles.
• Banks and similar financial institutions.
• Junk securities.
• Flailing companies.
• Low-tech and old-tech capital equipment producers.
• Commercial real estate.
• Commodities.
• Developing country stocks and bonds.
• Japan—a slow train wreck

Pg. 425:
Investments to buy:
• Treasuries and other high-quality bonds.
• Income-producing securities. (especially dividend producing stocks)
• Food and other consumer staples.
• Small luxuries.
• The U.S. dollar
• Investment advisers and financial planners.
• Factory-built housing and rental apartments.
• Health care.
• Productivity enhancers.
• North American energy.
• (I would add funds like VAIPX until other investors catch on to the deflation)

Pg. 375: In early 2009, Congress relaxed accounting standards that required banks to mark commercial mortgages down to market. Compliance would have eliminated much or all of their capital in many cases. But between 2010 and 2014, about $800 billion of that mortgage debt held by banks comes due, and about two-thirds of the loans are underwater.

Pg. 433: Note that TIPS do not work well in taxable accounts. Also, if Shilling is correct about deflation, Treasury bonds will be much better than inflation protected devices. If Treasury bond yields settle in to 3 percent in the years ahead, their returns will be attractive in the deflationary climate with 5 to 6 percent real yields. Similarly, high-quality corporate and municipal bonds are likely to be attractive on the basis of their real yields.

Pg. 447: Diversification and rebalancing will no longer work. The correlations of all asset classes except Treasuries, the yen, and gold were essentially 1.0 during the latest crisis, they all went down.

Pg. 462: The recent strength in gold prices suggests that many investors distrust all currencies, not just the dollar. Nevertheless, the supply of gold is far too small, even at current prices, to again serve as money. Gold in private and government hands is worth about $5 trillion, compared to global M3 money supply of $60 trillion. Gold would have to sell at $13,164 per ounce to equal M3.

Pg. 462: The U.S. versus the European Union:
Americans are lucky because this country was largely developed after the advent of the railroad. That and Lincoln’s decision to keep the nation together at all costs has given us a huge economy with a common language and culture and tremendous labor mobility—just the ticket in an era of globalization and its economies of scale. In contrast, Europe was developed when travel was by foot or horseback. The result is a continent of diverse countries that is fun to visit since there’s a different culture only 50 miles away. But it’s hell in today’s economic world due to language and cultural barriers and the lack of labor mobility.

Pg. 482: In the aftermath of the 1930s, the norm for annual home rentals was 10 percent of the house’s value. Shilling believes that if he is right about deflation, houses and apartment may again sell for closer to 10 times rentals than the fairly recent 15 times norm, and the 20 times in the housing boom days.

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