Thursday, September 16, 2010

The Mass of Markets

I am not here to pick any fights this week. Nor to tell my readers how all the more famous investors and economists of the world are getting it wrong (they must be doing something right since they are famous, and I am not quite so much).  Instead I want to focus on some interesting statistics about markets and economies that can help frame a perspective about markets. The size of different markets, along with the size of different market participants, is something that is little talked about in the main stream investment mediums. This is what I am calling the Mass of Markets, and in some future post may be so brave as to try and detail these relationships; but first, a primer.
It is widely known that the U.S. GDP, overall measure of economic activity, weighs in at about $14.5 Trillion.



Below is a chart from the International Monetary Fund IMF on how this compares to rest of the world.



For 2009

As you can see, the whole of the European Union, added together, is a larger economic market than the United States by a couple Trillion dollars. Also note that in 2010, it is widely accepted that China has surpassed Japan as the second largest national economy in the world.

It is also fairly well known that we have a debt problem here in the United States and currently have a National Debt that comes it at around $12 Trillion. This is akin to a household having a debt load of roughly 80% of its annual income. We also find that we run a budget deficit of 10% of GDP. This means that our debt load is growing right now at about $1.5 Trillion per year. 

The question is; when does this burden break our backs? Well, by comparison Japan has a Debt load of roughly 180% of its GDP and can still find willing lenders in the open markets. While we do not want to emulate Japan, (remember some of my last posts on deflation talks), this does show that an economy may not fall apart under this kind an even greater debt load. Someone should poll the Japanese and find out how their standard of living is. From what I have read, the citizens of Japan are not rioting in the streets.  In fact, they are still the biggest purchasers of their governments debt.  Japanese sentiment is a topic for another day.

Now look at this. The total mortgage debt load in the U.S. weighs it at $14.9 Trillion as of the last quarter of '08 (according to the federal reserve). This means that there are more households owing more money on their homes than all the goods and services sold in the United States (sounds incredible until you stop to think about the number of households in the country). Of this nearly $15 Trillion, $9.2 Trillion has been pooled, sliced and sold off on secondary markets. This is what is called securitization; the mortgage bonds that were the ignition of our global financial crisis.

The important thing to remember about this is that back in 2007 and 2008, when some of the pools that contained what I call NINJA (No Income No Job or Assets) loans, and those people began having trouble paying back those loans, we experienced what Mohammad El-Erian, CEO of PIMCO referred to in his book, When Markets Collide, as a Market for Lemons. A Market for Lemons is an economic theory that suggests if you have one or two terribly problematic cars on a used car lot, the price of the good cars can also be brought down by the fear the customer has of getting sold a "lemon". This is exactly what occurred in the $9 Trillion dollar market for securitized mortgage loans. People were afraid of getting sold junk and the whole market seemed suspect.

Some people said that the problem would be contained in housing. Well its hard to see of a $9 Trillion dollar market not having an impact on the greater economy. For comparison purposes here are some other market figures.

Market Cap of the Wilshire 5000 (actually over 6000 companies in the U.S.) - $12.7 Trillion

The biggest 500 of those, the S&P 500 - $10.2 Trillion

Total U.S. Bond market in 2008 weighed in at around $33 Trillion. We can add in another $5 Trillion or so of additional government debt and money market instruments that have been added in the last two years.

The largest U.S. corporation in terms of market capitalization is Exxon Mobil (XOM) at $310 Billion.  In second place is Apple (AAPL) at $252 Billion.

The value of all the gold ever mined in the world stands right now at about $6.3 Trillion based on a price of around $1250 per troy ounce.  Five years ago that was a less than a $2 Trillion market.

What does all this mean?  It means that the more massive a market, the bigger its gravitational pull on other markets.  For instance, if Apple gets some bad news and Ipads dont sell as well as they expected, the whole market index can feel a hit.  However, a small bio-tech company can go out of business without so much as a headline.

This same relationship plays out in bigger markets.  Many big investors will point out the fact that, while the stock market is a lot sexier, the Bond market really calls the shots in the economy.  This is, in part, because as the biggest and most liquid market in the world, it has a deeper and more far reaching effect on people.  Now we can talk all day about the structural differences in the different markets, but the point remains that mass should not be over looked.

Investors would do well to remember Newton when venturing into the global financial market arena.

3 comments:

  1. This comment has been removed by the author.

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  2. I like the way you are taking a very macro perspective in looking at the various markets. It is important to pull all that together before attempting any analysis or to draw out cause and effect relationships.

    On the subject of comparing the debt load of the U.S. to that of Japan, I have to disagree. Japan is only able to carry such a high amount of debt because their citizens have a high savings rate and use those savings to buy government bonds. Japanese culture is somewhat conservative financially, making the average citizen more likely to purchase bonds than invest in equities. The interest rate in Japan has been kept low for a very extended period of time, enabling the Japanese government to borrow money cheaply. If Japan was forced to borrow money on the international bond market, they would be forced to pay higher interest rates and after a few years the cost to service their debt would rise and make their debt load a serious problem.

    In the U.S., most government debt is sold to China and other trading partners. The biggest factor driving this trend is the trade imbalance between the U.S. and China. If the trade imbalance goes away (something hard to imagine today), so would the willingness of the Chinese to buy U.S. bonds.

    I don't think it is reasonable to assume that China has the appetite to continue purchasing U.S. debt until we reach 180% of GDP. The Fed would have to directly purchase bonds for our national debt to reach that level, something that would undoubtedly spook investors both domestic and international. As the Japanese population continues to age and the number of workers paying taxes declines, their debt load will become evermore untenable. At some point they will either default or massively devalue their currency.

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  3. Thank you for the comment! Again I appreciate the feedback as usual.

    As a point of clarification, I do not believe that our government could carry the same debt load as our Japanese friends for the very reason you outline. That being said I think there is something to be said for people who think our current debt load is unbearable. I believe that we do have some wiggle room in that regard, hopefully only for any other emergency situation.

    The issue with China is a tough one. As I mentioned in my post about China, they have just as much to lose, if not more, by not buying our debt securities. A run on the Treasury would ruin them financially. If they stop buying, or even significantly slow their rate of buying our government debt, it could trigger other market participants to sell and cause the value of their reserves to plummet.

    China is working currently on a planned diversification, which, if we dont get on board, and reduce our debt level accordingly over time, they may finally find themselves in a position where they would be willing to stop buying treasuries all together.

    Japan is in big trouble no doubt. They are trying a planned devaluation right now, and we will see how that plays out. Lets just hope that the U.S. can figure out how to get that 80% debt load down to 50 or 60.

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