The bulls are clearly back in charge of the stock market. Companies report poor results and/or poor forecasts, the shares sell off and are then bid right back up again. Any bad news is deemed to be the last bad news, the future is rosy as the bailing buckets from a panicking government swing ever faster. Too bad the leaks are getting bigger, as the credit meltdown in housing is spreading to commercial real estate and corporate securities.

Hopefully the rally has enough legs to create a really good shorting opportunity. Looks like the energy price bubble is at least cracking, with crude oil now down about $20 from its peak. If oil continues to drop, which it should as the recession bites, doubtless there will be a boost to bullish sentiment. At some point, though, folks will figure out that oil isn’t and wasn’t the problem, just a gratuitous piling-on. The real problem is that the financial system is gravely wounded. The broker/dealers were the first to suffer, because they are both more aggressive and more leveraged. But the pain will trickle down to the smallest bank, with 60% of domestic loans in real estate, how can it not?

A sophisticated presentation from the New York Times, The Debt Trap. Especially the interactive chart of a century of debt and savings (under “lifetime”), that puts today’s staggering household debt burden into perspective.

One looks at that chart and says, wow, what a bull market in credit. Consumer credit in various forms has been around for millennia, but it seems like it really exploded after World War II. The effect of rising consumer credit and falling savings rates is to accelerate consumption.

Going back in time, people saved to buy a house. Then, as we move along the timeline, they just saved for a down payment, but expected to save the rest later as a function of their mortgage payment. Then they didn’t need to wait to save a down payment. Then they didn’t need to save the balance - to amortize the mortgage balance. Over time, they expected the appreciation of the house to not only cover the interest, but to supplement their incomes. At each step, people expected to be able to buy a house earlier and earlier in the life cycle of their household. Price also became less of an issue at each step, and so houses became bigger and more costly. Most recently, price sensitivity even became inverted, as a more expensive house was seen to generate more dollars of appreciation and bigger tax savings.

We see the same phenomenon in other lifetime purchases, such as a college education, which have clearly gone through similar structural shifts. Particularly the price-raising part, in the case of colleges. So we had more and more debt, moving earlier and earlier in the household life cycle over a long period of time.

If you drew a household life cycle as a timeline, you could divide it into three segments, a savings segment, a debt servicing segment and a retirement segment. As debt has increased, the debt servicing segment has spread out to take over the other two segments. When we reached the point where a newly formed household expected to buy a house immediately, in addition to servicing their student loans, and would likely end up at retirement with outstanding debt still to service, we reached some kind of a limit. “You can’t get blood out of a turnip”.

I was watching the Suze Orman show last night. The show has this “can I afford it?” segment. I was particularly struck by the guy who was making $7,000 a month who wanted to buy a new Bentley convertible for $212,000. He was, admittedly, debt free except for an existing car lease of, I think it was, $695. He claimed to be able to finance the Bentley at 6.5%. I fired up my trusty HP-12C which shows that the monthly payment on a 48-month loan would be $5027.57. So his total car payments would be $5,700 or so. And then, of course, there are operating costs. How was he going to eat? People just do not understand the implications of buying on credit.

Consumption has to balance with income over the household life cycle. That is, if I buy a Bentley Continental, I have to cover the depreciation on that puppy from my income or my savings. So that may mean less money to spend on other things now, or I may choose to burn my savings and have less to spend in retirement. People have chosen to burn their savings on consumption, in general. That lack of savings for retirement is the demographic part of the debt trap that many analysts have observed.

The other part of the debt trap is that, so long as the debt servicing part of the lifecycle continues to expand, consumption is being pulled forward. But it eventually reaches a limit, when consumption is pulled so far leftward that it cannot move any further. I would argue that we have reached that point. Then aggregate debt cannot expand further than the present value of aggregate income for all households. In effect, real consumption cannot expand faster than real income. In fact, it has to shrink because retirement savings are clearly insufficient. As the baby boomers move through, the average household in the mix becomes older - further along the timeline - and transfer payments from younger households are going to have to be made in order to feed and house the elderly who have over-consumed and lack savings to sustain them.

The debt-servicing segment of the household life cycle will have to be shrunk to some equilibrium value, on average deferring consumption. As this equilibrium point is found, aggregate consumption will fall drastically. The tailwind that increasing debt has given to economic growth will reverse to a howling headwind. Other developed countries will suffer similar circumstances. Countries, such as China, which are in a different phase of economic development, still emphasising savings over debt, will be moving to equilibrium from the other side, giving them much stronger internal growth.

But, you retort, all this debt is just paper accounting, isn’t it? It is just money that we owe to ourselves, after all. The economy has been pumping out all the goods and services that we need, why won’t it continue to do so, indefinitely? Sure, savers aren’t going to get rewarded in goods and services as they expected, because the borrowers won’t be repaying. But, over all, why should consumption fade when the capacity to produce all the SUVs and cellphones and bottled water that people want is obviously there? Manufacturing productivity keeps rising, doesn’t it?

Ah, I respond, then let me count some of the ways that productive capacity will decline.

• Malinvestment. Over this long secular trend, massive investment has been made in things like housebuilding and the associated financial services that will not be needed in the future. Shifting the economy to produce other things will subtract productive capacity from the economy while the shift is being made. We have enough SUVs. And probably enough cellphones and bottled water, too.
• Underinvestment. Bridges are falling down and highways are cracking. Why is the price of oil so high? Because of insufficient investment in energy production. Energy production capacity is declining, which is affecting the supply of goods and services in that they become scarcer and hence more costly. Inadequate maintenance of infrastructure saps productive capacity. Everything is wearing out and not being replaced. Another shift in the economy to produce different goods and services.
• Overconsumption (or underproduction). The US is no longer self-sufficient in anything. We consume more than we can make. It is simply untrue to say that this debt is money we owe to ourselves, much of it is owed to foreigners who have delivered goods and services to the US. All you need to see is the impact of defaults on foreign banks and investors reported in the press almost daily. That debt needs to be serviced, and it is serviced by goods and services that we send overseas in return for those that we have received in the past. Production will shift to increase emphasis on goods and services our foreign creditors will want.

In summary, the economy will change, and will lose productive capacity while changing. The change will be massive, as it will represent a reversal in a hundred-year-old trend. It is the end of an empire built on credit.

I know everything is fine according to Mr Bernanke, who believes the economy will continue to grow. Or more precisely, who says he believes the economy will continue to grow. And senior government officials don’t lie, do they? But maybe we should take a look around:

• There are pictures of bank runs in the media, complete with police to keep order in the line.
• Entire subdivisions of new houses stand empty, ghost towns that were never inhabited.
• In many areas, foreclosures account for the majority of house sales.
• General Motors is “restructuring” and laying off employees for the second time this year.
• The SEC is restricting short selling in certain financial stocks.

There had been much talk about eliminating short selling. The NYSE now requested lists of all holders of borrowed stock (short sellers). The rush to cover to stay off the list and to realize profits assisted in ending the decline.

The discount rate was reduced again, to 4 1/2%. Congress rushed a tax cut. Rockefeller ordered 1 million shares of Standard Oil at 50. An order for 50,000 shares of U.S. Steel at 150 “pegged” that speculative leader. Its drop from 261 3/4 to 165 had been the bellwether of the crash.

The gyrations quieted. The stock market rallied in quiet trading for the rest of November 1929.

Markets are euphoric today because the price of crude oil has fallen a few dollars. Ignored in the general rejoicing, apparently, is the record low (16) reported in the NAHB homebuilder confidence index. Basically this says that no-one is showing up to look at new houses, let alone buy them. Shouldn’t be surprising, but don’t lose sight of the fact that this is the big asset class - real estate. I looked at the CMBX indices last night, and , sure enough, spreads are rising in all the commercial mortgage indices as well. Many are at record highs, especially the low quality ones. This reflects the massive overbuilding in commercial real estate, especially retail. We haven’t heard much from this sector, but we will soon.

Wells Fargo reported a decent quarter this morning. Bulls pumped the shares 25%, claiming that WFC was home safe, while ignoring the one-time effect of changing the charge-off date for equity lines from 4 months to 6 months delinquency as of April 1st.

The stock market thrashes around under the control of the program traders; it is expiration week, after all. The economic news is poor - producer prices up 9.2% year-over-year, nominal retail sales up 0.1%, which means a fall in real terms. The SEC is restricting short-selling of shares of the GSEs and the brokers, which is another sign of panic - and by the way, shows the SEC’s real mission of protecting the industry from its customers. Financial stocks are up a bit, but the real energy continues to be focused on the over-loved and over-priced technology stocks, which are still well above their March lows (as represented by the Nasdaq 100, anyway). Oil fell today, although it needs to fall a lot more to make any economic difference.

The market is still ludicrously overpriced. Must be that dark energy holding it up, countering the force of gravity. Do dark pools contain dark energy?

Edit: And for a chuckle. Well half a chuckle, half a sigh. Recession-Plagued Nation Demands New Bubble To Invest In. A little too close to the truth, I fear.