Reduce your debt now, warns one of Wall Street's top fund managers, even if it means slowing down growth -- hard times lie ahead
Inflation is over, depression is coming, warns Stanley D. Salvigsen, the Paul Revere of Wall Street. For several years, Salvigsen has been imploring the locals to reduce their borrowings and to safeguard their houses and businesses, but until disaster struck last fall, few citizens paid heed. What suddenly transformed the 45-year-old chairman and chief executive officer of Comstock Partners Inc. into an alarmist with authority was the fact that hardly a month before Black Monday, he sold out the equity holdings of a $100-million mutual fund his advisory firm manages.
The tactic was so convincingly prescient that shortly Salvigsen was able to go public on the New York Stock Exchange with his own investment pool, the Comstock Partners Strategy Fund. And there were plenty of believers: the IPO took in a massive $1.2 billion, one of the largest equity offerings of any kind ever. Not one to suspend his own disinflationary theses any longer than necessary, by close of business the next day, all 10 figures had been invested. Not in stocks, of course, nor even in AAA-rated corporate bonds, but virtually all in the most reliable securities the free world offers -- debt obligations of the U.S. Treasury.
For investors stuck with stocks they paid too much for and don't know what to do with, Salvigsen has become a visionary. Unfortunately for them, his vision is even bleaker than ever, as revealed in this interview conducted by INC. senior writer Robert A. Mamis at Comstock Partners' Manhattan offices. Among his near-term worries: hard times spreading to other sectors beyond the Oil Patch and Farm Belt, a crash in real estate from Los Angeles to New York, and interest rates declining to spectacularly low levels due to a stultified economy.
To give wider voice to his concerns, Salvigsen left his position as chief investment strategist at Merrill Lynch Capital Markets in 1986 -- the very year he was named the industry's top portfolio strategist by Institutional Investor magazine -- and, together with two former Merrill Lynch associates, Charles L. Minter and Michael C. Aronstein, founded Comstock Partners. The trio now consult with institutional clients and can be hired to manage portfolios for individuals and corporations. In case you're interested after reading this month's interview, the minimum amount is $50 million.* * *
INC.: Last October's 500-plus-point stock-market dip seems not to have startled many people in the end. Are you still holding to your dismal precrash view of depressions rolling through the economy?
SALVIGSEN: The current willingness to dismiss the '87 crash as an event unto itself with no important consequences in the real economy is wishful thinking in the extreme. The crash wasn't the beginning of an immediate recession, necessarily, but we think it started the deceleration process in the system. It marked the beginning of the end of the credit inflation that began in the 1960s, and its implications are considerable. Until we see otherwise, we'll stick with that.* * *
INC.: Even though you're dismissed in some circles as gloom-and-doomers?
SALVIGSEN: We are not doomsdayers. All we're saying is that for at least 25 years, debt growth has become synonymous with growth. That the system grows on credit is not revolutionary. We argue that the system isn't growing fast enough to service all its debt. It's not even growing fast enough to keep up with the compounding of the interest on the debt. Our theory is that after the best-quality paper, such as U.S. Treasuries, goes to a higher rate of return than major corporations can earn on their equity, the system shuts down. People would rather just buy that paper than construct a plant to make the paper.
INC.: Yet bulls insist that our system of economics is a perpetual-motion machine -- that it can be manipulated and sustained.
SALVIGSEN: We say debt is cumulative and eventually debilitating. It's like walking up an incline with a backpack; throw a rock in the backpack every mile or two, and at some point your knees buckle.* * *
INC.: Can you put that in concrete terms?
SALVIGSEN: When you start with a clean balance sheet, like America had 25 years ago in the early '60s, the first incremental dollar of debt is like a stimulant, because it's very easy to service. It's like getting an extra unit of growth for nothing. That works, so let's use some more of that debt, and some more of it. You're getting the juice of using the extra credit. Spend it today, owe it in the future. But credit is cumulative. What used to be stimulative starts to become regressive, because the credit market makes a distinction; it says this is not as safe as it used to be. There's not enough gross national product to go around for all this debt. So interest rates go up. That's what has been happening in the '80s.* * *
INC.: Are you saying the economy has to expand at a faster rate than the interest rate? No way.
SALVIGSEN: Well, if it doesn't, it's falling behind. Part of our rationale is that the interest on the interest is sapping the lifeblood of the system. You have $11 trillion worth of debt, and it has an interest rate of 9%. Every year, the debt accrues nearly $1 trillion in interest alone, not even including what's added in borrowing. The base GNP -- the total wherewithal that society has to pay back its debts -- is only about $4 trillion a year. Interest amounts to more than a quarter of the total GNP. If total interest paid increases by 10%, nominal GNP has to grow by about 20% merely to cover the incremental interest that's accruing, with no growth, no nothing.* * *
INC.: If GNP can't keep up, what are the consequences?
SALVIGSEN: We believe interest rates are going to go down to 60% next year by this time.* * *
INC.: Because business will be bad?
SALVIGSEN: That is our most likely scenario.* * *
INC.: Can rates plummet that fast?
SALVIGSEN: They went from 15% to 10% in about 18 months from '81 to '83. They went from 14% to 7% from '84 to '86 -- less than two years -- and they did half of that in 5 months. It's not so outrageous. People think it is, but it's happened twice already in the '80s. One of the problems we see in dealing with the present environment is that none of the people in charge has ever been in charge at a time when there was this much debt per dollar of GNP. For instance, last fall Mr. Greenspan said something like: "Hmmm, this economy has gotten quite strong; oil rose to $22 in the spot market in July, national statistics are firming up, why don't we raise short rates a little bit?" So he did. Wham! Stock markets crashed from 40% to 50% all around the world.* * *
INC.: On the other hand, now that we've been where we are for a while, why can't we hang in between, say, 8% and 10% for as long as need be?
SALVIGSEN: Debt level is the key. The debt level has gone from $2 trillion in 1967 to $11 trillion now. The most debt we ever had before was $192 billion coming into the '30s -- which is what caused that crash. It was a much smaller economy, of course, but in relation to the GNP, it was about what we have now. Debt works like a vacuum cleaner -- helpful at one end of the scale, but if it starts sucking up the furniture and the house and the entire town, it has to be turned off. Debt is compounding at such a rate relative to anything else that, in a 20-year period, the lenders will have all the money.* * *
INC.: Certainly 9% isn't that much interest.
SALVIGSEN: Really? Just to give you an idea of the incredible effect of compounding, if you bought a zero-coupon Treasury bond today at 9%, it would be like guaranteeing the Dow Jones Industrials would be at 30,000-plus in the year 2018. By the Rule of 72 [divide 72 by the rate to get the doubling effect of compound interest], every eight years you're going to double. The trouble is, it works the same way when you have to pay it: if you keep compounding interest at 4% faster than the GNP, eventually the whole world will be working only to pay interest.* * *
INC.: Why are you suddenly worried now? Isn't inflation worse?
SALVIGSEN: When you borrowed and bought things and the things you bought went up because of inflation, there was no problem. It's only when the things you buy stop going up that there's a problem. Tangible assets haven't gone up much since 1981, but borrowers need inflation to help pay their debts down. When they don't get that inflation, there is more risk. Debt has grown 15% faster than GNP over the past six years. Therefore, there is less chance of lenders getting paid back now, because there is more debt per unit of ability to pay it back.* * *
INC.: Risk has always been a tenet of capitalism. There's nothing exceptional to the notion that excess keeps getting reinvested at risk.
SALVIGSEN: But after 25 years, people are treating debt as if it had no risk. Business statements don't adjust earnings for credit. They adjust them for inflation and everything else, but not for risk. Credit is looked at almost like an asset. "What do you mean you don't have any debt?" "Oh, I'm sorry, I'll go out and get some." Yet interest costs affect your ability to price competitively. If you're competing against a German or Japanese who's paying 4% locally, and you're paying 9%, that's as if you had expensive labor. You can't be a low-cost producer that way.* * *
INC.: You'd literally like to see a factor for leverage on the left side of the balance sheet?
SALVIGSEN: Sure. Everyone says today return on equity is good at about 15%. You can go back 25 years and still find 15% return on equity, but back then there was hardly any credit used to generate it. Today, there's a lot of leverage in that balance sheet.* * *
INC.: But generally speaking, there has been an ability to pay it back.
SALVIGSEN: I'm sure the people who had borrowed in the farm and energy sectors thought that inflation of either the crop price or the energy price was going to bail out the borrowing. Instead, the price of the collateral went down, and assets were foreclosed against the debt.* * *
INC.: You're concerned even though the economy has technically been expansive for the past six years?
SALVIGSEN: True, no recession has officially struck since 1982, but the definition of a recession as two consecutive quarters of negative real growth is the formula of certain rule-making economists. That's like police defining a riot as an altercation involving 100 or more persons, and refusing to send out the force if only 90 people are rampaging through the streets with Uzis.
If you were in the farm sector in the early '80s or in energy in the mid-1980s or in exports throughout most of the '80s, you would insist that in fact a depression was raging.* * *
INC.: But the rages have quieted down. The energy and farm sectors recovered to a large degree, and stocks retraced a good portion of their drop. Now, it looks like business as usual.
SALVIGSEN: It depends on what you mean by usual. One of the market's messages in October was that inflated profitability in the consumption and service sectors is unsustainable. Excessive debt and debt service will bring the curtain down on the consumer goods and service sectors as well. Blaming the October affair merely on program trading and portfolio insurance is like blaming the sacking of Carthage on Hannibal's elephants.* * *
INC.: The odd thing is, it seems to have been the deep pockets of consumers that stemmed the stock panic and kept business strong -- from new-car sales to upscale yogurt. Obviously, there still are a lot of spenders.
SALVIGSEN: Judging from the activity we see in acquisitions and LBOs in the luxury-goods group, it strikes us that the market is making its usual dangerous assumptions that any anomaly, if it persists long enough, can be embraced as a new standard of normalcy. Half a million dollars for a house in New Jersey is not the new standard. Urban real estate is another sector in danger of collapse.* * *
INC.: You mean our own homes? What are the signs?
SALVIGSEN: Real estate is the major collateral behind most of the debt out there. Second mortgages have become a widespread means of consumption financing. As debt becomes liquidated -- as we think it will -- the prices of houses behind that debt have to come down. For Sale signs start sprouting up and down the street. It hasn't happened yet in the Northeast, and things are still crazy in California, but there's a high potential for real estate cracking. Look at foreclosures, with a spike where we are right now. And if you plot delinquencies on mortgages, it would look about the same. Real estate owned by banks other than their own premises is exploding. And in the past two or three years, the number of cities in which the average price of homes has turned down has been increasing.
INC.: What would you do if you owned a house that had appreciated by eight- or tenfold, as many have?
SALVIGSEN: If I owed $400,000 on a $600,000 home, I'd sell it and ask the new owner to lease it back to me. Balloons and second mortgages are very dangerous. If I had two homes, I would sell one immediately without a doubt. Of course, you wouldn't do it in Houston, where houses already have crashed.* * *
INC.: Since it's already happened in Houston, can you take us through the process?
SALVIGSEN: What happened there is when the price of oil went up, it pulled wages up. The person earning the wage goes into the bank, and the bank qualifies him for a lot more loan -- some multiple of his annual wages is now considered safe to lend to this person. So his potential spending power increases as his wage goes up, and that bids up the price of houses. Inflation is credit based, as we see it.
In this case, the credit that was loaned to the wage was tied to the price of oil. Then when the price of oil cracked, it reversed the process. And also deflated the value of the real estate. The only thing it didn't deflate was the loan that was owed. So there goes the home.* * *
INC.: For many small-business owners, most of their personal net worth is their business. Should they be concerned with their companies as well as their houses?
SALVIGSEN: Especially if they're leveraged. They've got to have something invested for the downside. Invariably, it's leverage that forces people to do the wrong thing at the wrong time. In a recession, there are always guys with perfectly good businesses trying to hang in for one more quarter, but the creditors say sorry, we can't carry you anymore. It seems prudent here to get your business in shape so that during hard times, you're not forced to lose it.* * *
INC.: If you were a small business and had debt on your balance sheet, would you try to clean it up?
SALVIGSEN: It would depend on what industry you're in, but growth in general for everybody will be something less than currently expected. What we have seen from each of the major accidents in the past six or seven years is that somebody should have said early on, "I'm willing to sacrifice growth to get rid of some of this debt, because if the growth doesn't materialize, I'm dead." The realities of the marketplace are that most of the restructurings take place after you get caught. It seems to be the seizure of assets that sobers people up. They don't change their attitude until they get caught. They will borrow as long as nothing goes wrong.* * *
INC.: It would take a courageous chief executive officer to do otherwise. Since his function is to keep growing, turning conservative always has to happen after the fact.
SALVIGSEN: That's why it's peculiar advice. We give it, and we know only a very small percentage will take it. Particularly when you see competitors come in and take market share, using leverage to do it. Then you feel if you don't borrow, you'll get squeezed out.* * *
INC.: If you owned a plant, would you sell and lease back?
SALVIGSEN: It depends on the region. If you were in Texas or Louisiana or some other place that already had had a 40% haircut, you'd probably be better off buying. But if you're in a region that has been unscathed, yes, I'd do that. It makes sense for businesses to do some selling of tangible assets and invest the capital in something that benefits from our scenario of rapidly declining rates.* * *
INC.: Such as?
SALVIGSEN: The long-term U.S. Treasury bond is the only investment that can really benefit if interest rates go down to the median rate of return of the past 200 years. The long bond will be in demand, so it won't hurt to move into it early on. There are three other forces that are going to have to buy that same piece of paper. The Social Security Administration, which has built up incredible surpluses -- those funds must be invested in Treasury obligations. The same thing for the FASB [Financial Accounting Standards Board's] 87 financial disclosure rule coming next year, which will cause the private pension-fund system to move more into safe bonds. Then there's the aging of the yuppies.
INC.: What influence will they have?
SALVIGSEN: As yuppies get older they'll go for bonds like they went for Reeboks. Yuppies are responsible for putting all this debt on the books. They bid up the price of housing, and they used a lot of credit. Like anyone else, as yuppies pass into midlife over the next 15 years, that same generation has to get out from under borrowed money and the illiquid assets it is paying for, and consolidate into liquid assets that are income producing. We don't think that can be a smooth adjustment. Because to whom will they sell their five-bedroom barns, if the population behind them is smaller and the older people want smaller dwellings?* * *
INC.: In your scheme of rolling depressions, couldn't business in general stay healthy while certain sectors suffer setbacks and recover? Perhaps you don't have so bleak a view as it sounds at first.
SALVIGSEN: That's true. It's not nearly as bleak as the word depression implies -- as long as the debt liquidation rolls through the economy sector by sector. What would make it bleak is if all the sectors entered a rolling depression at once. Then you would have a real debacle, such as the 1930s.* * *
INC.: Otherwise, what?
SALVIGSEN: You can appreciate the rolling-depression setting by noting what happens when banks decide to loan a sector a lot of money. In the Farm Belt, they loaned the farmers all the money they needed for whatever reason -- tractors with air-conditioners and tape decks -- in the early '80s. It seemed safe. How could they miss? People need to eat; we'll feed the world. Brokerage firms were accumulating farmland to sell to their investors. When you step back, it was ridiculous. How could people afford to eat with wheat at $6 a bushel, when they couldn't afford to eat at half that price? You saw what happened: the farmers got killed. So then banks wouldn't loan to the farmer anymore, and they had to find another sector. Where did they loan the money in '81 to '84? To the Oil Belt. Capital rushed to Houston and Dallas, and there was building all over the place. Then energy got killed. It's easy to determine who will get it next: the sector that is attracting the capital. Since we hit the wall in 1981, every time a sector attracts capital, that sector gets killed.* * *
INC.: To wit, Wall Street?
SALVIGSEN: I don't think anyone who lives in the Northeast would argue that there are not excesses on Wall Street. BMWs are the tape-decked tractors. What is the easiest loan to take out right now? A home loan. Not in Houston, but where the financial sector is prospering -- in Manhattan, and Boston, and Chicago.* * *
INC.: What would precipitate a full-scale depression?
SALVIGSEN: A depression in the classical sense means you have a net credit liquidation for the whole system. So far this decade, you've had credit liquidations in the farm and energy sectors, but consumer borrowing and government borrowing offset them. So the aggregate debt load has continued to climb. At some point you run the risk of undergoing a national liquidation.
That probably gets triggered more by policy error than anything else. Everybody says you can't have a depression because nobody will let you. Except you've had about nine of them so far, and somebody let them happen.* * *
INC.: What is your worst-case scenario for the public?
SALVIGSEN: A worst case would follow from a mistake in policy in the middle of an average recession. Stopping credit growth too quickly would be such a mistake. If the feds raised taxes and raised the discount rate, and shrunk the money supply even more than they have already, there is a possibility of a cataclysmic event. With this much debt, it is very hard to judge how much you pull on the string before the string pops. Even a midsize recession at this point would be brutal, with all this debt. People with debt will find themselves without an income; businesspeople with a lot of LBO debt on the balance sheet will find themselves without the cash flow they've been counting on to service the debt.* * *
INC.: How about if we're already liquid?
SALVIGSEN: Another worst case that people don't appreciate is when interest rates go down from here without the stock market going up. You'd be amazed at how few can benefit from that scenario. Especially large pools of money like private pension funds, endowment funds, the state pension systems, and so on, which are obliged to pay out a lot of money in the future. If they're not protected, that also will be catastrophic, because they won't be able to meet their actuarial obligations. The actuaries have predicted -- incorrectly -- that if interest rates go down, stocks will go up, and everything will be protected.* * *
INC.: How much can bonds rally with rates as low as 9%?
SALVIGSEN: Low? Rates today are still twice as high as the 200-year average of interest rates in this country. We think 1981 was to bonds what 1932 was to stocks. Rates had gone to 15% and people were throwing bonds overboard. Now rates are 9%, and they say look how low the rates are.* * *
INC.: All free economies are highly leveraged these days. Does that mean they're all teetering on the brink?
SALVIGSEN: I view Japan as the big excess of the '80s. Japan is to the '80s as the United States was to the '20s. We were not the reserve currency then, but we were the economy that was taking market share from most of the trading partners. The excess liquidity -- trade surpluses -- found its way into the stock market. Our market in the 1920s went up much more than most of our trading partners'. That's what has been happening in the '80s. Japan's trade surplus built up at an incredibly fast rate, and it went right into the financial markets. As the financial markets rose, they pushed up real-estate values. Then many Japanese borrowed against that real estate, went overseas, and bought yet more real estate. The valuation of the Japanese stock market is very rich by traditional standards.* * *
INC.: Yet their economy is not as extended as ours, right?
SALVIGSEN: The debt in Japan is only about half GNP, whereas in this country it's close to three times GNP. There the excess is in price: real estate, stocks, goods. It's a rigged economy. When a cantaloupe costs $75, to us it's laughable. Wouldn't you think someone could ship them a melon for under 50 bucks? The deflationary risk to their domestic pricing structure is very great. I see the risk much greater in Japan than in the States.* * *
INC.: Could Japan collapse without dragging us with it?
SALVIGSEN: There would probably be a sympathetic directional move of most markets, since the Japanese market is so big. We could go down a lot, but not anywhere near what the Japanese market could go down. To go back to the parallels with the '20s, our stock market then fell 90%, but England -- which is like where we are today in relation to Japan -- went down only 40%.* * *
INC.: What would be the consequences of a collapse in Japan?
SALVIGSEN: What happens in a crisis like that is money goes to the safest haven. The dollar would turn up significantly if there were a crash in the Japanese market. The dollar turning up would make our market look particularly attractive; investors would say: "Hey, the value is relatively cheap and the currency is going the right way." That's one factor that will keep our market from participating.* * *
INC.: Even if the idea of growth in America has been sacred, can't we sustain a level that is flat just as well?
SALVIGSEN: The biggest growth element in the United States today is debt. Therefore the luxury of having the flexibility of settling for less rapid growth is out of the question. The only way this country is going to manage its debts now is to increase its output, not consume more services. Part of how we got here is we consumed too much. Standard of living is measured by consumption. It isn't adjusted for how much credit is used to gain it, which is absurd.* * *
INC.: Let's explore the response if things got real bad.
SALVIGSEN: If the system got real weak, the response of the government would be to print. And it wouldn't help. Once you go over the edge, the contraction in velocity is so great that they can print all the money they want, and it doesn't make a lot of difference. The other possibility is, let's say you had someone who was really sharp, and anticipated: "I think this system is going off the edge, so I'm going to print now to prevent it from happening." What would happen then is that under present circumstances, the dollar would drop like a rock, and that would bring on the deflation anyhow. If all of a sudden the purchasing power of the world's biggest customer fell 30%, vendors waiting to sell that customer something would feel as if a bomb had dropped. You would have effectively exported your deflation to them by running down your currency. Then there could be a worldwide depression.
INC.: What would you have us do, then?
SALVIGSEN: Don't get caught in the middle of the flock. We have discovered a zoological quirk that illuminates the matter. It seems that when a herd of camels finishes imbibing at the local oasis and then feels nature's call, rather than each wandering about in search of a quiet tree, they crowd together and relieve themselves at exactly the same moment. When the number of participants is large, it makes for quite a scene. Keeping in mind that one man's debt burden is another's green fee, we emphasize the necessity of making the shift from borrower to saver and from low-quality instruments to creditworthy and long-lived ones, before the entire herd stands up and lets fly.