The Debt Storm Is Coming

While we can debate until we are blue in the face the actual ins and outs of what causes recessions, most would agree that high debt loads play a significant role. If we look back at the 2008-2009 recession, this is very true. Or the dot.com bubble bursting, debt played a large role. Even go a little further back into history and look at the 1929 stock market crash and subsequent recession, mostly fueled by margin trading (investors trading with borrowed money, i.e., using debt to fuel larger trades).

At this point, not many people are talking about the United States current debt levels. Not only is the U.S. government's debt level out of control, but more importantly consumer debt levels are also out of control, and that is likely the more concerning issue.

When consumer debt gets out of hand, first we begin to see increased levels of defaults. That leads to reduced levels of credit as the institutions who lend credit begin to tighten their requirements to borrow. With less available credit, consumers begin spending less on discretionary purchases because they either can't get credit or have maxed out what credit they did possess. Lower spending leads to lower profitability for consumer facing companies, which then leads to a reduced number of jobs in those sectors.

The chain reaction can continue to other sectors of the economy, such as say the energy sector because with fewer jobs and less merchandise being sold, fewer customers and employees are driving to stores or work and there are fewer trucks making deliveries. (This just being one of many examples of how high debt and reduced consumer spending affects other sectors of the economy, there are many other industries that are affected.)

So why am I talking about how debt affects the economy today? Well because U.S. consumer debt has once again hit all-time highs. Per the New York Federal Reserve in the second quarter of 2017 outstanding household debt rose by 0.9% or $114 billion to a total of $12.84 trillion. This new record comes after the debt figure reached during the first quarter of 2017 was the first time household debt topped its previous record which was set in 2008.

Credit card balances in the second quarter grew by 2.6% to $780 billion, auto loans jumped 2% to $1.19 trillion, and mortgage debt jumped 0.7%. Credit card delinquencies rose for the third straight quarter, while auto and student loan debt more than 90 days past due also increased. Overall 4.8% of outstanding debt balances were delinquent during the quarter. Furthermore, household debt is 15% higher than where it was just four years ago when the financial crisis and impact of the recession was still fresh in the minds of consumers.

The Senior Vice President of the New York Fed said: "The current state of credit card delinquency flows can be an early indicator of future trends, and we will closely monitor the degree to which this uptick is predictive of further consumer distress.”

While it would appear we are still in the early stage before a recession, it would also appear there is already writing appearing on the wall that the next recession is coming.

So, how do you prepare for a recession? Well first, sell your retail stocks. As I explained above, retail, consumer discretionary is one of the first industries to be hit. Owning consumer discretionary ETF's such as the Consumer Discretionary Select Sector SPDR Fund (XLY) or the Vanguard Consumer Discretionary ETF (VCR) would be a bad idea. But you could buy something like the Direxion Daily Consumer Staples Bear 1X Shares ETF (SPLZ) or the ProShares UltraShort Consumer Goods ETF (SZK) which are both ETF's that short the retail sector.

Besides retail, it would also appear the auto industry may be in for a tough time. Auto loan delinquencies hit their highest level since the financial crisis for the first time back during the fourth quarter of 2016. With low gas prices, more American's have opted for the large truck and SUV's, which along with their size come with large payments.

Furthermore, over the past few years, we have seen the number of new cars sales rise and rise. Most Americans today have a 'newer' car. If they begin to feel pressed due to a recession, it's unlikely updating a vehicle that’s only a few years old will be a priority.

So avoiding the First Trust NASDAQ Global Auto Index Fund (CARZ), which is a fund that tracks a market-cap weighted index of global auto manufacturing companies, would probably be a good idea.

And finally, the as we saw after the financial crisis began, the main reason a recession grows worse is the lack of available credit. While some consumers may not use credit for consumer discretionary items or even vehicles, buying a home is one purchase nearly all Americans make using credit. The housing industry will take a hit again if we fall into another recession and therefore the house stocks or any of the homebuilder ETF's like the SPDR S&P Homebuilders ETF (XHB) will take a hit.

While increasing debt levels are a clear indication a recession is looming, the fact of the matter is we could still go months or even years until it happens. But, you need to begin preparing yourself for the coming bear market, because once it is evident that we are in a recession, it is usually too late.

Matt Thalman
INO.com Contributor - ETFs
Follow me on Twitter @mthalman5513

Disclosure: This contributor did not own shares of any investment mentioned above at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.