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Tough times ahead for U.S. consumers will lead to stock market crash, says fund manager

by Wayne Cheveldayoff, 2005-10-06

Is your investment portfolio ready for the possibility that the U.S. consumer spending boom will turn into a bust this winter and sink the U.S. stock market?

That prediction comes from a Canadian fund manager with a reputation for making the right calls and profiting from them.

Eric Sprott, lead manager at Sprott Asset Management (www.sprott.com), recently devoted an investment letter to examining the vulnerability of the U.S. consumer in a period of escalating energy prices.

“As winter approaches, there’s an all-out assault occurring on consumers’ pocketbooks – one that promises to have profound effects on U.S. economic activity. Yet stock markets, for the most part, remain completely oblivious to any pending problem,” he states.

“Consumer spending comprises over two thirds of the U.S. economy. We believe that as the consumer’s spending power goes, so will U.S. housing prices. And as housing prices go, so may a financial hurricane be unleashed that will bring the house of cards called the stock market crashing down.”

The U.S. consumer has surprisingly continued to borrow and spend beyond what most economists expected or think prudent, leading to a negative savings rate as consumption has exceeded income in recent months.

But some cracks are starting to appear. U.S. consumer confidence has declined and statistics issued in the last week of September showed U.S. personal spending fell in August by the most in more than three years as Americans delayed non-essential purchases to pay for soaring fuel bills.

There is a good chance we’ll see more declines in the months ahead. With natural gas and heating oil prices up over 50 per cent from a year ago, consumers will continue to be under pressure through the entire winter.

Sprott notes that among the other factors “conspiring to put the big hurt on consumers’ wallets this winter” is a new requirement on U.S. credit card companies to raise the minimum payment on credit card balances from two to four per cent. On an outstanding balance of $5,000, a doubling of the minimum payment will mean an extra $100 per month.

Suppose the higher energy prices and credit card payments cause consumers to fork over an extra $400 per month through the winter months.
“How much mortgage can $400 per month buy? Assuming a traditional 30-year mortgage at the prevailing mortgage rate of 5.7 per cent, $400 monthly buys you $70,000 of house. Factor in the tax deductibility of mortgage payments and let’s call it $50,000. That’s a substantial amount of house, especially considering that the median price on an existing home is currently $218,000.”

With the consumer very stretched already, Sprott thinks it reasonable to expect some negative impact on housing prices.

And if housing prices fall, this would put a further crimp on consumer spending because Americans will have less potential to suck money out of their home equity through refinancing their mortgages.

Such mortgage refinancings have been an enormous boost for consumers in recent years, in the order of $600 to $700 billion annually.

“Needless to say, this party will likely come to an end in short order. Combine that with the significant stock market correction that we foresee, and the negative wealth effects will only add insult to injury to the consumer’s already constrained pocketbook.

“We are at a loss to envisage how the consumer can survive such an onslaught. How the (stock) market can view the upcoming slowdown as anything but anathema to corporate earnings and stock valuations is beyond us. We believe it won’t.”

Sprott’s predictions may be on the mark. If you also factor in continued rate hikes by the Federal Reserve to curtail energy-driven inflation and the U.S. Government’s inability to cut taxes again because of its enormous operating deficit, it is hard to believe that the consumer buying spree will simply continue as before.

Sprott’s success as a portfolio manager also speaks volumes in favour of paying attention to his views.

The Sprott Canadian Equity Fund, heavily weighted in gold and energy due to his bullish views on those sectors, has produced average annual returns of 28 per cent for the five years ended August 31, versus an average annual return of only 1 per cent for the S&P/TSX Composite Total Return Index.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2005 Wayne Cheveldayoff