As small business owners we need to make decisions that will have long-term consequences.
Therefore, we need to make long-term assumptions about what will happen in our industry and to the economy in which we work. There is a huge amount of financial data and news these days. There are so many signals that it is hard to keep up with absorbing and analyzing them all.
I look for simplicity. Here’s a simple financial indicator to watch.
Debt Service Ratio.
First, I start with the following assumptions:
- Most Americans don’t have much net worth (see chart below)
- Most family’s net worth is tied up in their house
- Most houses, and other large items, are purchased on credit (if our net worth is low, how else can we buy things?)
- Housing has had a huge run up lately- lots of sales, lots of appreciation
- 2/3rds of the US economy is based on consumer spending
Therefore, most Americans live either paycheck to paycheck, or close. Here’s an indication, the data is from 1996, but I’m confident the numbers have changed little of late.
If so, then folks who loaded up on debt will have to cut back on spending.
If that’s true, then the spending will have to drop pretty dramatically to let folks get back down to a debt level they can comfortably manage.
Based on the Debt Service Ratio (basically debt payments divided into income) chart below, good times and easy money in the 80’s and 90’s, led Americans to take on debt payments of around 12% of their monthly income before recession forced them back down to a more comfortable level of 10% during the recessions of the early 80’s and 90’s.
Notice that the debt service ratio has now risen to over 14%.
Are we that much more sure of our jobs now? (A: No)
Is America in a much better position in the world? (A: No)
Does the government have budget surpluses to spend in hopes of creating a soft-landing for the economy? (A: No)
Unfortunately, since our last tough time in the early 90’s, the following has occurred:
- We have gone from the being the largest creditor nation in the world to being the largest debtor… that’s our government, not just us as citizens.
- We’ve shipped a lot of manufacturing jobs overseas.
- We’ve spent a lot of good lives, hard cash, and international goodwill on some questionable military adventures. (whether we had any choice but to do so is outside of the scope of this article.)
- Our government has relied on the Chinese to buy the bulk of its debt for the past several years, now they hold over $1 Trillion of it. As the dollar has weakened, they have lost a lot of value, so it makes sense for them to buy less of it in the future.
Cycles of Creative Destruction
As an undergraduate, I studied economic history. One thing that became clear was that as economies expand, shift, and contract there are always winners and always losers. Here’s the good part, the economy expands and contracts in somewhat predictable cycles, based on human psychology and a number of other factors.
There are a number of cycles, a general business cycle and also a real estate cycle (among others.)
These cycles are generally created by times of easy money and speculation leading to rising prices and lots of investment, expansion, and building followed by all the excesses of the previous years coming home to roost; poorly-run businesses folding, companies and families with too much debt losing a grip on the assets they were so excited about grabbing up while things went up, up, up.
As this starts, the banks who made so much money lending on the way up suddenly decide that the climate is too risky and make loans much more difficult to get. Suddenly, you can’t sell a property or refinance a business if you have to, so prices begin to drop. No one wants to be the one left with the expensive house or business still on the market while, logically, no buyer wants to sign on the dotted line when the price next month will probably be lower.
Is any of this sounding familiar?
Suddenly, the market just dries up and some folks take big losses and business close their doors. Some economists call this churn Creative Destruction.
Amidst all the rubble, some folks get rich. My great grandfather owned an auto body shop in Michigan during the Great Depression. He made money fixing the cars no one could afford to replace. He rolled that money into buying up shares of local banks that no one else dared to buy. Of course, when the economy finally recovered during World War II, he reaped big rewards as suddenly those banks seemed like the greatest investment around.
Musical Chairs
Take a look around. Is there a chair close by that you’d feel comfortable in?
The needle is lifting off the record, the music is stopping. It’s time to find a nice place to sit while our nation recovers from this easy-money induced hangover. It may take a few to several years to get our debt levels down to more manageable levels.
Of course, I may be wrong… but I’d hate to be the one who bet against history. Take a look at that chart again, what’s the shape of that curve? How far above the average band are we?
Oh, and today, a big shocker, non-farm payrolls shed 63,000 jobs last month, far more than the markets and economists expected. So, how are those folks going to pay their bills next month? It’s no wonder that foreclosure rates hit a 23-year high last month.
What do you need to do to prepare yourself and your business for the coming days?
What might you do to position yourself to benefit from the Creative Destruction ahead?
Do you wish your business was making a bigger contribution to your personal net worth?
Stephen Sloan is the Extendo-CEO. He not only advises small business owners on leadership issues, he helps them with their work on a project basis. Learn more here
Tags: Current Events, Decisions, Economy, Leadership
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