David Rosen­berg has issued yet another piece of blis­ter­ing com­mon sense (which most main­stream and sell­side econ­o­mists seem to lack in whole­sale amounts these days), in which he explains why the action at the mar­gin is all that mat­ters for asset prices and all that fol­lows. As he says "this is about change, not lev­els" — a jab directly at the Fed­eral Reserve, whose core under­ly­ing premise is that "stock" is all that mat­ters, whereas "flow" (or change) is irrel­e­vant. This is arguably one of the biggest errors that Fed chair­man after Fed chair­man per­pet­u­ates, and fur­ther explains why the Fed will always have to be engaged in some (ever greater) form of mon­e­tary inter­ven­tion in order to sim­ply keep asset prices con­stant as the "stock" the­ory is dis­proven time and time again. Alas, since we are deal­ing with bril­liant PhD Econ­o­mists they will never admit their fool­ish the­ory is flawed until it is too late. In the mean­time, for every­one else who does not live in Bernanke's ivory tow­ers, here is Rosenberg's expla­na­tion why what hap­pens at the mar­gin is all that matters.

Change Is At The Margin

One of the ques­tions we have been asked recently was what under­pinned our once-controversial but now more main­stream call that this econ­omy was head­ing for a severe slow­down, which it cer­tainly has this year. Our main mes­sage all along was that the debt binge of the past three decades was unsus­tain­able. The pun­dits who insist that the Amer­i­can con­sumers will never retrench have been con­di­tioned by the mag­ni­tude of the run of the super-credit cycle and are con­fus­ing "resilience" with "lever­age". Mean­while, only a recent decline in the per­sonal sav­ings rate has pre­vented more notable ero­sion in spend­ing growth in recent months.

In order to fore­cast where we are going, it is essen­tial to thor­oughly under­stand where we have been. We came off the most pro­nounced credit cycle in his­tory. Between the end of the 2001 reces­sion and the end of the 2007 expan­sion, the aggre­gate house­hold debt-to-disposable income ratio surged from 100% to a record of 136%. In just over six years, the per­sonal sec­tor was able to tack on as much debt to this ratio as in the prior 40 years com­bined. This six per­cent­age point run-up per year was triple what was "nor­mal" in other eco­nomic up-cycles. Most of this, as we found out in such dra­matic fash­ion, were loans extended to house­holds who were either dra­mat­i­cally expand­ing their real estate port­fo­lio or tap­ping home equity through loans for con­sumer spend­ing in other areas apart from housing.

Exces­sive debt has remained a prob­lem across the full spec­trum of house­holds. The uni­ver­sal con­fi­dence in the qual­ity of real estate as col­lat­eral fos­tered an envi­ron­ment in which bor­row­ers and lenders alike were will­ing to aban­don pru­dence in the rapid cre­ation of res­i­den­tial mort­gage debt. Sub-prime lend­ing, to house­holds with no stated income, no assets and poor credit his­tory, was just the most glar­ing exam­ple of how wide­spread credit avail­abil­ity became dan­ger­ous in the face of the par­a­bolic rise in home prices. In the mania, par­tic­i­pa­tion was extremely broad. The hous­ing bub­ble was never about "con­sumer resilience". It was about lever­age — unfet­tered access to credit. And we con­tinue to pay the price for this largesse today as house­holds con­tinue in this defla­tion­ary delever­ag­ing cycle and home­builders con­tinue to try and work off lin­ger­ing excess inventory.

Those who assess the macro and mar­ket scene at the mar­gin seem to con­sis­tently have an advan­tage over those who don't. In other words, this is about change, not lev­els. Arthur Zeikel, the renowned for­mer pres­i­dent of Mer­rill Lynch Asset Man­age­ment, pre­sented a leg­endary report in the late 1980s titled On Think­ing that illus­trated the impor­tance of under­stand­ing that change occurs at the margin.

Sup­ply and demand at the mar­gin in the real estate mar­ket con­sists of those who have "For Sale" signs on the lawn and those who are actively look­ing to buy. The price of the entire mar­ket is in their hands, not in the hands of those who are con­fi­dently sit­ting tight. This is impor­tant because it was the action at the mar­gin that took prices par­a­bolic, and all home­own­ers ben­e­fited dur­ing the bub­ble. Every­one except the 30% that rent felt the wealth loss as house price gains reversed course, even those with no mort­gage debt out­stand­ing. More sell­ers plus fewer buy­ers equals home price defla­tion, and that is still the excess sup­ply back­drop pre­vail­ing today, fully four years fol­low­ing the ini­tial det­o­na­tion in res­i­den­tial real estate.

The movie is run­ning back­wards now because, at the mar­gin, there are still many more sell­ers at all points on the spec­trum, and fewer buy­ers as well. As a result, all home­own­ers will very likely con­tinue to expe­ri­ence the effects of home price defla­tion in many urban areas. Yet, because home prices are such an emo­tional topic, most econ­o­mists are afraid to con­sider what a sus­tained depre­ci­a­tion in hous­ing prices will do to their fore­cast. In our opin­ion, they place their clients at a disadvantage.

From Arthur Zeikel;

"As all of us were taught, but most of us have long since for­got­ten, eco­nomic change occurs at the mar­gin, where the action takes place... indi­vid­u­als who can think on the mar­gin always have an advan­tage over those who cannot."

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