HS Dent Publishing

Life in the Great Recession

By: Rodney Johnson, President

From the smallest decisions we make in our personal lives (do I buy that DVD or just rent it
for a $1 from Redbox?) to the sweeping changes at the federal level (mandatory health
insurance for all) we are witnessing a shift. We have walked through the entrance door of the
Great Recession—the second coming of the Great Depression—and indeed, things are different.
The ground rules of how we operate in our personal lives, communities, and states, at work and
as a nation, have changed from a perspective of growth to one of conservation. Some of the
changes we have made on our own; some have been foisted upon us. Just as each of us would like to conserve
as much of what we have as possible in terms of our wealth and standard of living, we also would like to
preserve or even to expand what we receive in terms of services from our governmental agencies. These two
ideas are at odds, and most of us will end up caught at the flashpoint of where these notions collide and will
see our incomes decline and taxes increase. One lesson that we must learn is that as we go through this
difficult economic season we have to get used to the idea of less.

This does not mean that there is no way to earn more revenue, greater profits, or investment income! What it
does mean is that we are no longer living in a period marked by an ever-rising tide of economic activity that
covers up poor or questionable decisions. We have entered an era in which those who are shrewd and
discerning with their business decisions and investment selections will do well while others continue to see
their assets whittled away.

Entering the Next Economic Season

In the hundreds or thousands of presentations that I gave during the boom years, one question kept coming
up: “What should we be watching to know when we have turned the corner into the long winter?” The answer
was simple–consumer expenditures. The Bureau of Economic Analysis tracks consumer expenditures
quarterly. Adjusted for inflation, they are shown in Chart 1 from 1990 through March 2010. You will notice
that, except for a brief time in 1991-1992, consumption expenditures consistently have gone up until the
recent downturn. This happened through the Russian bond default, the Tech Bubble busting, 9/11, hurricane
Katrina, etc. We just kept spending more—and now we’ve reigned ourselves in. We are spending less. While
the measure has recently a touch higher off the lows, this
is not a resurgence in consumption growth but instead a Personal Consumption Expenditures
sign of bottom bouncing as we find a new normality at a Adjusted for Inflation
lower level. Not only are we spending less in aggregate,
but we are spending a lot less on durable goods: those
items that last more than a few months, like cars and
washing machines. These are typically the things that we
finance, and that leverage goes a long way toward
creating a supercharger affect for the economy.

If you purchase a $30,000 car for 10% down, then you

have used 10-to-1 leverage to consume. You have to pay
off the $27,000 debt plus interest over time, but you
spent $30,000 immediately, pulling future demand into
the present and paying the dealership, the manufacturer,
etc. When we as consumers slow down this type of
Source: Bureau of Economic Analysis Chart 1
leveraged consumption, it has the reverse affect, acting

Copyright 2010, HS Dent Publishing

as a severe dampener on our economy. If one less car is sold in a month under this example, it would mean
that while the consumer saved $3,000 that month, the car company and its various suppliers had a $30,000
drop in revenue. This is why economists look so gravely serious when they use the word “deleveraging.” They
know how bad this is.

When we slow our purchase of durable goods, we slow our use of debt, which cools down the economy, slowing
job growth and wage growth, and can even lead to job destruction and wage cuts—as we see today with a near-
double-digit unemployment rate. As we have noted many times at HS Dent, Americans, led by the Baby
Boomers, have turned the corner and are now becoming savers, not spenders. The fall in consumption
accompanied by a rise in savings is precisely the situation that can lead to long-term deflationary trends. As
consumers spend less, producers cut costs by cutting wages and/or jobs. Thus, employees have less to spend,
which starts the cycle anew. This is also the reason you must view any “green shoots” with skepticism.

Employment is Worse Than Portrayed, and Where Jobs Exist, They Aren’t the Same

The reported unemployment number in June was 9.5%. Thus, it would be reasonable to estimate that almost
10% of the available civilian workforce was out of work. However this is not what the reported unemployment
number represents. The current measure (called U3) represents a sort of core group of the unemployed,
meaning those who have been unemployed for less than a year, are actively looking for a job, and have not
taken a part-time job. If you are unemployed and have not looked for a job in the last four weeks, the
government does not count you. If you are unemployed but take a job waiting tables to make ends meet until
you find a true replacement job, the government does not count you. If these people were included, the
measure of unemployment would be almost 17%, not 9.5%. This broader measure is called U6. U6 is much
closer to what we intuitively would think of as the unemployed.

One more adjustment to unemployment has been made: the removal of those who are unemployed and have
not looked for a job in the past year. This group is simply not acknowledged at all—they are not considered
part of the workforce. This change in how unemployment is calculated was made in the 1990s. John Williams
of Shadow Government Statistics (www.shadowstats.com) attempts to back out the changes that the
government makes to statistics such as unemployment so that current figures can be compared to historic
numbers.. By his estimate, our unemployment rate would be north of 20% if we used the same measure today
that we did up until the early 1960s.

In addition to simply having less people employed, those who still have a job are working less and therefore
earning less. At the low, the measure of the hours worked per week in the U.S. fell to 33, the lowest level
since that measurement began (Chart 2). It has since rebounded slightly. Of course, with falling hours comes
falling take home pay. Gone are the days of overtime. In some areas, such as state workers in California, there
have been mandatory cuts in hours across the board to reduce payroll expenses. There can be no clearer
example than this of having your employment contracted. Imagine working for the State of California in
whatever capacity and being told that the good news is that you get to keep your job, but the bad news is that
starting next pay day you will receive 14% less. No one came along and commensurately reduced your bills.
Thus, to keep your budget in line, you must curtail
expenditures. Number of Hours Worked
The example of state workers in California illustrates that
not everyone who is recently unemployed was a banker
for JP Morgan. As the U.S. economy has slowed we have
seen a severe jolt to unemployment that has cut across
all lines. Twenty-five years ago President Reagan
described the situation in the mid-1980s as a rolling
recession, one that hit individual industries quite hard
while the overall economy continued to grow. We saw this
rolling recession idea again in the tech and finance
sectors in 2000-2002, but the current situation is the
exact opposite. While areas such as finance, including
mortgages, are hard hit right now, the pain is also being
felt in construction, technology, manufacturing, services,
teaching, farming, etc. Source: St. Louis Fed Chart 2

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In short, we are experiencing a tremendous disruption in employment that not only reaches broadly across
industries, but that also affects those still employed. The fact that we are seeing job creation of 30,000 or 80,000
is of no comfort whatsoever when the number of unemployed is over 15 million and we add approximately
100,000 job seekers every month due to new entries in the workforce (college and high school graduates). For
those who call unemployment a lagging indicator, it has been true that employment gains typically are not seen
until a recovery has already begun. This is not a “typical” post-WWII recession, however, and it is worth noting
that during the Great Depression unemployment did not peak until four years after the depression had started.
We could see rising unemployment or have unemployment remain elevated for a very long time as consumption
remains muted and borrowing remains soft.

For those who have lost jobs as well as those that are new to the job market, the prospects for employment are
a jolt. News reports are full of stories of people who have taken positions that pay substantially less than either
they made before or than they were anticipating. This is particularly true in the area of finance, where not only
“front office” people, those involved in sales, trading, investment banking, etc., lost their jobs, but thousands of
“back office” employees also were let go. There simply are not, and will not any time soon, be enough positions
in this field to employ these people, and certainly not at the level of pay they had achieved previously.

Household Balance Sheets Decline at the Wrong Time

The ravaging of the equity markets and real estate markets has hit households at the point of their greatest
assets—their investment accounts (IRAs, 401ks, etc.) and their homes. On the asset side, we are poorer. The
Federal Reserve reports that the assets of households and nonprofits fell $15 trillion, which is just over 15%
from the recent highs. This makes sense in light of falling home prices and the dramatic decline in the markets.

On the liabilities side, we are reducing our debts, but not nearly as quickly as our assets are declining. As our
assets fell by $15 trillion, our liabilities only fell by $2 trillion. Why? Because our biggest liability is typically our
home mortgage, which doesn’t simply go away just because the value of the home fell or because we lost our
job.

This compression of household balance sheets is occurring just as the peak number of boomers move into their
savings phase of life (ages 48 to 64). This group is clearly focused on their future, providing for themselves in
retirement, which is coming on quickly. Their personal goals and their economic decisions will be driven in large
part based on how to repair their personal balance sheets, building up assets and shedding liabilities. As falling
home prices, dropping investment accounts, wage cuts, and job losses take their toll, this very large group of
the population will be even more fiscally conservative than they otherwise might have been. This is not a recipe
for expanding personal consumption.

The Crunch at the Local Government Level

Cities and states are among the worst-hit entities, as their revenues are generated from three main sources—
income tax, property tax, and sales tax—that are all in decline. In the case of income tax, the fall has been
dramatic. Corporations as well as individuals are reporting much lower income; therefore, tax receipts based on
that income have fallen. Local governments are a microcosm of the states. They are rapidly depleting their funds
and see little relief ahead.

We have seen California lead the way in passing state budgets that are a mix of spending cuts, accounting
gimmicks, and forced borrowing (issuing IOUs). That has temporarily filled the gap. But what of tomorrow?
Property taxes typically move in long trends because of caps on increases tied to appraised values as well as a
lag in appraisals themselves. After two years or more of watching their property values decline, property owners
will be lining up to demand that their appraised values match up to what is happening on the street. This will
cause a plummet in what has been a stable revenue source across the country. The timeline for watching this
situation evolve is not measured in days, weeks, or even months. The full affect will take place over years.

“States are responding to historic drops in revenue by enacting the largest tax increases in decades,
and growing budget gaps will likely lead to further tax increases and spending reductions, Rockefeller
Institute Senior Fellow Donald J. Boyd told a meeting of the Governmental Research Association in
Washington, D.C. on July 27. Early evidence suggests states are cutting assistance to local
governments, and some are reducing public payrolls. While state tax revenue historically recovers
quickly after a recession, such recovery will likely not emerge until some time after the federal stimulus

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Copyright 2010, HS Dent Publishing
 harry s. dent, jr.
assistance expires in 2012, Boyd said. He warned of “a new round of very difficult revenue and
spending decisions in January-June of 2010.” [Rockefeller Institute e-alert, July 29, 2009]

The Response of the Federal Government

In the past year we have been inundated with acronyms meant to help the financial crisis (TARP, TALF, TLGP,
etc.) by providing liquidity to banks, which presumably then would lend to businesses and individuals. We
were given a $787 billion stimulus that sought to fill the budget holes at the state level, to provide
unemployment and healthcare benefits, to provide education dollars, and to start some new programs that
would create new jobs. Both of these efforts had the same end game in mind, which was to create a temporary
patch on the economy that would give it time to heal so that we could return to “organic growth.” The term
organic growth here means a belief on the part of consumers that their lot will be better in the future in terms
of jobs and income as created by increased consumption. The problem is that this growth is nowhere in sight.

As we look at the normal drivers of growth in private consumption, which would typically lead to organic
growth of the economy, we see that none of these traditional growth stimulators exist in the current economy.
Consumers need confidence in the growth of the economy before they use debt to increase their expenditures.
In addition to our research, which points to a lack of desire to spend among consumers, the economic
slowdown is across most if not all economic sectors. Unemployment is rising so quickly and so dramatically
as to create a tremendous barrier to any resumption of consumption because of lack of income as well as fear
over potential job loss or income reduction. Added to unemployment are the remaining burdens of debt that
consumers still owe and the removal of credit facilities for marginal borrowers. In this situation, the stimulus
plans are not giving us a reprieve until growth returns. Instead, these plans are staving off until another day
the inevitable reckoning that we must face. Unfortunately, every day we put off this reckoning we rack up
greater national debt.

Businesses Face Continued Pressure

Businesses large and small are still struggling because consumption is not returning. While the latest
quarterly results showed profits, these tended to be due to cost cutting, which was accomplished in large part
by cutting jobs. One of the most telling measures on the business side is capacity utilization, which tries to
gauge how much of our installed production capacity is being used. Chart 3 shows that we are currently
running at 72% of capacity after reaching a historic low of 68% Business is slack. Revenue is down and is
expected to fall further. In response, businesses have cut employees, and as noted in the section on
employment above, the numbers of hours worked by remaining employees have dwindled. Businesses have
cut their production to match their sales, so profits have returned, but that does not mean that those profits
must be used to expand. Expand for what? Where are the new clients?

A large unknown in the business world is what will happen in corporate real estate. Valuations are dropping,
and the ability to refinance the lending facilities on this
type of property has dwindled. Small banks, which Capacity Utilization
typically stayed out of the mortgage mess, were very
involved in corporate real estate. As valuations plunge
and short-term loans come due in the next twelve
months, this situation could cause severe disruptions at
banks around the country.

Where we Go from here?

Taxes Go Higher

The one thing that seems blindingly obvious is that we

will experience higher taxes across the board. This is not
just about federal taxes. This includes state taxes (as
noted above by the Rockefeller Institute), county and city
taxes, and most of all, fees. The easiest taxes to raise are
Source: St. Louis Fed Chart 3

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those that affect a small number of people and/or those on a good or service that is considered bad for you.
Cigarette taxes are a typical example. Approximately 20% of people in the U.S. smoke. Cities and states seem
to constantly be on the prowl to raise taxes on cigarettes, claiming that this is for health reasons. This could
not be further from the truth. If the goal were to stop people from smoking, then the pressure would be on to
outlaw smoking. Instead, if everyone stopped smoking, then all of the revenue generated from cigarette taxes
would be lost. The state of New York recently raised its cigarette tax once again. Now a pack of cigarettes in
New York City, will cost around $11 per pack. Outside the city, but still in New York, cigarettes are a relative
bargain at $9.00 per pack.

As property tax revenue declines due to falling valuations, locales will have no choice but to raise the millage
rate of taxation to recover some of their revenue. Remember, taxes on personal property and income are rarely
enough to pay for a city’s services. Taxes on businesses are required. However, if businesses are shutting
down, then the assessment on their property falls and the tax on their income goes away. This shifts a greater
burden to the individual homeowners in the area.

Increased Demand for Social Services

The government has a poor record of estimating the cost of any social service. Medicare costs an order of
magnitude more than it was estimated, and Social Security is going broke. The only program around to be held
forth as an example of the national system is the Massachusetts plan, which requires everyone to obtain
coverage or to pay a penalty. There is also a public option that can be chosen. The result? The plan has been
in place for less than three years; it is 30% over budget, and is increasing in cost by 12% per year. The plan
is an absolute failure on the cost side. While the plan did lead to increased coverage, it is unsustainable even
in the short term. Massachusetts is clear on why their plan is failing. The government was counting on
healthy young people to sign up, to pay into the system, and to not use it, thereby subsidizing others who do
use it. By and large, these healthy young people have not signed up. They have chosen to pay the penalty.
Those who receive any form of subsidy from the system have signed up in much greater numbers than
anticipated. Also, Massachusetts expected the use of emergency facilities by the uninsured to drop by 75%.
This did not happen. The decline was instead closer to 30%. (For more on this view, see the following video
at CNBC, http://www.cnbc.com/id/15840232?video=1199225389&play=1, in which the Massachusetts
Treasurer discusses the issue.) There is no reason to believe a federal program would achieve any different
results.

On the tax revenue side, where there is a surtax on high-income earners, the U.S. government is modeling
income from the past, anticipating a recovery in the near future and a return to income levels as we had in
the mid 2000s. The federal government assumes that high-income individuals will continue to receive income
in the same way that they have, instead of attempting to recast their income in different ways to lower taxation.

The government also assumes it will squeeze costs out of the system to make it more efficient, which is just
as dubious of an assumption as their estimate of costs. The federal government has not shown its ability to
run programs of any size efficiently; it has over 40 years experience running Medicare very inefficiently. There
is no way to lend credence to the claim that this time it will be different. If that were the case, then we should
require the U.S. government to spend the next 24 months making Medicare efficient and then use the savings
generated to estimate what might occur in the new national program.

The discussion of social services goes well beyond the national healthcare debate. At the moment we are
cutting after-school programs, health care for the disabled, government-sponsored meals-on-wheels type
programs, etc. The reason that these programs are being cut around the country is to help governments at all
levels to balance their budgets. The problem is that the services were being used. We have effectively left the
least among us in the worst circumstances.

How We Respond

Dealing With Lower Pay

Regardless of the signs of recovery that are so often repeated in the news, people are beginning to cope with
the new reality that they face. The New York Times ran an article on June 7, 2009, in Section 1, entitled
“What’s Your Backup Plan?” The point of the article was to highlight that many high-income people are

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responding to the changing economy by pursuing a career in a field that they’ve always loved but that would
not make them rich. The article takes a light-hearted look at occupations such as pet massage therapist,
chocolate maker, and organic farmer. While this is a fun way to address the serious topic of the lack of the
same level of employment that people once enjoyed, the harsh reality for most people facing a step down in
job possibilities is that they simply spend less—a lot less.

As the Wall Street Journal reported in “From Ordering Steak and Lobster, to Serving It,” (June 2, 2009, page
A17), nearly 25,000 jobs have been lost in the financial sector since August 2007 and another 30,000 are
expected to be lost through 2011. This is just in New York City. The potential for the bulk of those people to
find similar employment in terms of income is extremely limited. The main person profiled in the article lists
the changes: his wife has returned to work, they quit dining out, they pulled their daughters out of ballet and
tumbling, and they cancelled cable TV. They also missed a mortgage payment and fear foreclosure and
possibly bankruptcy.

The consequences of downward pressure on income through job loss and then lower-paying work do not show
up immediately. There is a lag as consumers try to maintain the standard of living they once had. Given that
we are over 30 months into this recession and not only has unemployment remained high but also housing
has continued its slide, the probability of this being the end of the slowing in consumption is quite small. This
is why we continue to forecast that foreclosure rates have not peaked and that the drop in real estate prices
is not finished. There simply has not been enough time for the full impact of the changing employment picture
to work its way through the system yet.

Providing For Ourselves

While everyone is capable of buying discount cereal instead of the name brand, some reactions to the
downturn take time to learn. The D. Landreth Seed Company reports that sales were up 75% this spring over
last year. While the dangers of E. coli and other diseases play some part, so does the notion that growing food
is cheaper than buying it. Vegetable gardens are popping up across America in cityscapes as well as suburbia
and rural areas.

On the odder side, apparently a growing number of people are choosing not to use funeral homes, but instead
are burying their loved ones on their property. I’ve got to believe that this would not be allowed in urban or
suburban America where the bulk of our population lives, but the savings would be tremendous. With the
average American funeral costing $6,000, people will be looking for options.

Not Everything Will Decline

Recently the Washington Post ran a piece entitled, “What Recession?” (July 19, 2009). The article listed a
number of areas benefiting from the downturn. Among those listed were Amazon.com, guns, online dating,
movies, and certified pre-owned luxury cars. While the increase in weapons sales has a political component
(the possibility of a Democratic controlled Congress and executive branch strengthening gun control), the other
items point to clear decisions by consumers to make their dollars go further.

There is no question that going to the movies or renting Blu-ray discs is much cheaper than sending kids to
camp, and certified pre-owned luxury cars give buyers a chance to get into expensive cars for less. The most
telling item is Amazon, where we can see that shopping is not dead, it has just taken a different form. Now,
it might be worth waiting a few days to receive that lamp, mp3 player, book, etc., to save on the price.

Business Opportunities Abound

In addition to the questions of how to invest, we are often asked which businesses are going to be favored in
the future. The answer is simple in generic terms, and yet it is hard to pin down specifically. The businesses
that do the best will be those that are positioned to help consumers conserve. This can be in the form of true
dollars (bargains), energy, gasoline (yes, another form of energy), water, etc. Each case can be brought back
to money, because conserving energy implies purchasing less. This positioning of a business to assist
consumers in their quest for conservation will not just be in the outright form of providing goods and services
for less, it will also be in the branding.

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 I noted above the report that Amazon is enjoying a surge in business. As those who are frequent online
shoppers know, just because an item is sold online does not necessarily mean that it is cheaper than it would
be down the street, no matter what the seller claims. However, because it is sold online, it is perceived as
being less expensive. As any marketing department can tell you, perception is much more important than
reality when it comes to selling.

This goes back to the central theme of how we as business owners and investors should approach this
economic season: by understanding that it will be marked by less. This does not mean that consumption
stops, by any means. This means that in a world of excess supply, low-capacity utilization, and a desire on
the part of consumers to keep more of their money, the business model that will do well going forward will be
based on gaining market share at the expense of competitors. As we often point out, there were over 100 car
manufacturers in the U.S. in 1919. By the early 1930s there were 13. Those that survived ended up taking
market share from the weak competitors and emerged from the Great Depression as market leaders.

This, too, Will Pass

Finally, we sound a little like a broken record in that we continue to repeat the same theme: our economy goes
through long-term predictable cycles. Since Harry Dent began working with demographics and predictable
spending patterns, the forecast has always been for growth through the mid to late 2000s. (From the late
1980s to the mid 1990s, he fine-tuned his research and changed the end of the growth season from 2006 to
2008-2010.) This time would be followed by a period of economic contraction that would last for a decade, as
the Boomers slowed down in their consumption while their children, the Echo Boomers, had not yet ramped
up their own consumption.

The seeds of the next growth period have already been sown. As we point out, growth in spending is highly
correlated to family formation and the addition of children. The numbers of children born in 2007 and 2008
were exceptionally high, and as those children (who are the grandchildren of the Boomers) get older, their
parents will find themselves buying bigger cars, bigger houses, and more stuff. While we do not expect that
growth to rival what we experienced as the Boomers went down this path, it will be a period of growth
nonetheless.

For more of our research and to see what is on the mind of HS Dent, be sure to visit The HS
Dent Financial Blog at http://www.hsdent.com/blog/

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