The Black Box

[wahz]

The Fallacy of Composition
Steve Galbraith (Steve.Galbraith@@morganstanley.com)
Mary Viviano ([e-mail])
Michelle Weinstein ([e-mail])
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Rarely known for understatement, Wall Street is once again
engaging in amusing levels of hyperbole. The media,
never inclined to miss an opportunity to throw gasoline on a
smoldering fire, is adding to the fun. Instead of talking
about eyeball-based valuation models, 24/7 day-trading
opportunities, and a Palm Pilot in every pot, today’s focus is
on the more Malthusian extremes. The entire US population
is about to file for Chapter 11 (if they can avoid Chapter
7), no company will generate enough cash flow to ever
reward shareholders, pension funding issues will bankrupt
the country, and pigs will fly well before a single US company
raises prices again. Where have all the adults gone?
The reality is there is an awful lot of bad news out there.
Further, we are quite sure consumers will continue to file
for bankruptcy, debt holders are often in a far better position
than shareholders, pension issues will bring more corporate
Chapter 11 filings, and deflation will continue to plague all
kinds of companies. This all said, we suspect a number of
investors today are engaging (much as we did in our opening
two sentences to this missive) in a full-blown case of
fallacy of composition. Just because parts of the market
may be gangrenous does not necessarily ensure the whole
will be. Here’s our take on some current fallacies.

The US consumer will collectively file Chapter 11.

Our guess is there are few things more ironic than the sight of a
highly paid Wall Street talking head lecturing John Q. Public
about the irrational behavior of the US consumer. Okay,
maybe the sight of another highly paid talking head critiquing
his fellow talking heads about such hubris ranks up
there. In any instance, call us naïve but we have a hard
time buying into the party line that US consumers are a
bunch of lunatics in need of financial chastity belts. Who’s
the irrational one? If auto companies are throwing serious
bucks at me, and my working wife brings in all the dough
anyway, why shouldn’t I be inclined to buy a nifty new
Neon? More importantly, has no one noticed that folks
actually are saving more, and the latest Fed Survey of Consumer
Finance showed consumer indebtedness has improved
markedly? Now again, this is not to say
all is sweetness and light for the US consumer — it is not.
Indeed, we remain cautious on the consumer sectors of the
market. Rather, our point is explicitly to say that not all is
wrong with the consumer’s finances either.

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Exhibit 1
The US Consumer — Burdened Beasts?
Debt Service Burden 1992 1995 1998 2001
Aggregate 14.0 13.6 14.4 12.5
Median 15.3 15.6 18.1 16.0
Income Percentile
< 20 15.8 18.0 17.9 15.3
20-39.9 15.2 16.1 15.7 15.1
40-59.9 15.5 14.9 17.8 16.5
60-79.9 16.3 17.4 18.5 16.3
80-89.9 15.2 16.2 16.4 16.5
90-100 11.2 9.3 10.2 8.0
Debt as a % of total assets 14.5 14.6 14.3 12.1
Source: Federal Reserve Survey of Consumer Finance. Debt service burden =
debt payments as a percentage of disposable income
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Debt millstones mean no cash ever goes to shareholders.
If the consumer does not collapse under a crushing debt
burden, just wait a month — corporate America will drag
this whole Ponzi scheme down. Again, our view is not that
there are no significant debt issues in the market — the airlines,
telecommunications companies, select industrials, and
yes, many individual consumers clearly have too much debt.
On the other hand, Microsoft’s net cash position alone
would be the 35th largest stock in the entire S&P 500.
Reflecting recent cash hoarding, gross cash holdings relative
to the market’s capitalization are now at extraordinary
levels Further, pharmaceutical, energy, and cash-rich tech
companies and retailers make up the lion’s share of the
S&P’s market cap today. On the other hand, someone
clearly understands there is financial stress in the auto industry
today. GM and Ford’s combined equity market
capitalization is less than Microsoft’s cash holdings. Now
to be sure, GM’s and Ford’s importance to the economy is
greater than their nominal importance to the equity market.
As such, we would be remiss in simply dismissing what the
market seems to be telling us about their future prospects.
Nonetheless, if the auto manufacturers can just wheeze
along at a level commensurate with the muted expectations
priced into their securities, the market’s center can hold.