Unsustainable Economic Activity

"I think the American consumer recognizes they've got to hunker down, spend less, and they're doing it. Saks and Neiman Marcus have the worst sales on the planet, and the dollar stores and Wal-Mart are doing terrific because they offer value. That's a huge change in the mind-set of Americans. It's going to be with us forever. Living standards, of course, can never be the same. You can't put [the US] in this kind of financial condition. In our [federal] budget, we have 4% of the budget for debt service. That's going to go to 8. Now, when you do that, what happens to living standards?"

- Retail expert Howard Davidowitz on a May 14 Bloomberg Radio interview.

The day of reckoning has arrived for California's state government. It will not be pretty. Spending cuts and tax hikes are unavoidable; unlike the federal government, the state cannot monetize its debt with its own fiat currency. On June 10, California Controller John Chiang said in an official statement: "Without immediate solutions from the governor and legislature, we are less than 50 days away from a meltdown of state government."

The golden goose that funded irresponsible growth in state spending is dead. Chiang issued a report detailing a 39% year-over-year drop in personal income tax receipts, a 52% drop in corporate tax receipts, and an 8% drop in sales tax receipts.

Both consumer spending and capital investment will keep dropping in the state of California, because during the credit bubble, which paralleled growth in government spending, so much economic activity that would have taken place in the future was instead pulled into the present. Entrepreneurs suspect that state taxes on businesses will go up and will incorporate this into their plans.

"Sustainability" isn't just a word for environmentalists. In fact, it has a lot to do with the various stages of our financial crisis. In short, unsustainable economic activity fueled by easy credit will fade away quickly under tight credit. As economist Herb Stein said: "If something cannot go on forever, it will stop."

Like California's government, the consumer discretionary sector - which includes specialty retailers, restaurant chains, auto manufacturers, and more - has not been acting in a sustainable manner.

California's budget crisis provides a good example of what happens to institutions that wait until the last possible moment to correct mistakes and gets their fiscal houses in order. Like state governments, many businesses in the consumer discretionary sector must correct mistakes made during the bubble and write off uneconomic investments.

So while Wall Street's shortsighted focus is on the growth rate of the so-called "green shoots" of economic recovery, at Strategic Short Report, we're going to swoop in and seize not one, but two opportunities.

But first, you may ask why the consumer discretionary sector made so many uneconomic investment decisions. In hindsight, it was easy to see that we had, for example, too much auto production capacity. But in the heat of the credit bubble, it simply was easy to be fooled by artificially boosted trends in consumer demand. Think about it this way: Consumer borrowing and government budget deficits both pull what would have been future economic activity into the present, while pushing the associated costs into the future.

When this unsustainable behavior reaches its point of exhaustion, and people finally realize the folly of it all, employment falls, reckless investments are liquidated, and bad debts default. This is why it's healthier (yet politically unpopular) to have small, frequent recessions to keep supply and demand in balance, rather than have massive debt bubbles followed by nightmarish depressions and currency debasement. Such are the perils of government-promoted, debt-driven economic bubbles. It's like trying to live on a diet of candy and energy drinks, rather than wholesome food.

The 21st century gilded age for US consumers ended with the popping of the credit bubble. And this bubble was so big that it may take a decade for specialty retailers and restaurants to shrink store footprint, operations, and product lines to match a more sober customer. US consumers will save much more and spend only on things that provide clear value, and this will crimp demand for things like three-martini lunches.

Meanwhile, the stock market seems to have forgotten that we are facing a long-term adjustment in consumer behavior; it's distracted by noise surrounding the latest taxpayer-funded bailout. Market participants are also mesmerized at the spectacle of the Federal Reserve transforming its balance sheet into a toxic waste dump. It's like a bad reality television show that must up the ante to keep the audience interested.

Consumer discretionary stocks enjoyed full participation in the post- March 6 stock market rally. However, this sector must endure years of disappointing profits - thanks to the capital investments made during the bubble to meet a level of demand that turned out to be phony. As US consumer demand approaches a more sustainable level, the excess capacity in specialty consumer companies will come to light. In the coming years, bankruptcies, price wars, and shrinking competitive barriers will prompt the market to start treating these former darlings as "commodity companies."

Take another look at the lead quote from Howard Davidowitz, a widely recognized expert on the retail sector. He has lived through booms and busts, seen the rise and fall of winners and losers, and is not sugarcoating the return to sustainability in retail. The message is clear: Extravagance is out and frugality is in.

Davidowitz may not be an economist, but his point about the federal deficit is one that all rational economic actors understand. He emphasizes that you cannot overspend without eventually suffering consequences. There's no getting around the fact that as with California's budget, profit margins in the financial and consumer discretionary sectors must shrink. Sustainability matters. Even the federal government will recognize this as the market charges high interest rates to fund its deficits.

Regards,

Dan Amoss
for The Daily Reckoning

P.S. Our two new short ideas, accelerated growth during the bubble, and will have trouble adapting to the post-bubble economy. These higher-end restaurant chains reinvested virtually all of their profits - and lots of externally sourced capital too - into aggressive expansion. In the second half of 2009, the top stock market will realize that expansions of ornate restaurants were foolish investments. These restaurant chains are fragile species trying to survive in today's harsh economic habitat, hoping and waiting in vain for a return to a hospitable climate.

Put options on two restaurant chains could each return at least 150% in a few months. To learn how to take advantage of this play, see here.

Editor's Note: Dan is among our all-star line-up of speakers we have for this year's Agora Financial Investment Symposium in Vancouver, British Columbia.

The conference is rapidly approaching...and this year marks the 10th anniversary of The Daily Reckoning. So, this July, the Symposium will be focused around a "Decade of Reckoning"...four days that will help you to gain greater insight into the investment ideas and profit opportunities of the next decade.

This event is sure to sell-out...secure your spot now.