Comstock Partners, Inc.May 12, 2011
An Ominous-Looking Market Top
The market is giving distinct signs that the previously strong rally is fading and that investors and speculators alike are paying greater attention to the headwinds that we have been discussing in these comments for the last few months. Last week we pointed out how suddenly everything that was going up turned sharply down and that everything that was going down moved up. On a more gradual basis we note that stocks have made no progress now for almost three months. The S&P 500 reached 1344 on February 18th and today closed virtually at the same level---1348. Since investors invariably try to buy on dips what they most recently missed, some bouncing around is likely as the market forms a top. Nevertheless we believe the groundwork for a big decline is now being set at a time when the vast majority is still bullish. The following sums up our concerns.
1) Underlying all of the specific problems is the massive debt, both government and household, built up over the last few decades, but particularly the most recent one. Household debt has averaged about 55% of GDP over the last 60 years, but recently peaked at 98%, and is now still at 91%. As a percent of disposable personal income, household debt has averaged 75% with a recent top of 130% and is currently at 117%. Similarly, government debt has averaged 66% of GDP and is now at a peak of 108%, as government debt has recently risen more than private debt has dropped. The need to cut back on debt will inhibit economic growth for many years to come.
2) QE2 is ending on June 30th. The program will, by that time, have pumped $600 billion into the economy, meeting Chairmen Bernanke's stated goal of jump-starting the stock market. The end of the program is a defacto tightening of monetary policy. While the Fed's balance sheet won't be reduced anytime soon, the key point is that it won't be increasing by an average of $3.8 billion a day as it has since mid-November.
3) Fiscal policy is about to tighten as well. This is obviously what the ongoing discussions in Washington are all about. The fact is, that one way or another, both sides are more or less in agreement that the Federal deficit has to be reduced. So, whatever the merits, both monetary and fiscal policy will be less easy in the period ahead. That is a headwind against economic growth and the stock market.
4) The European Union's (EU) sovereign debt problem is not just a headline risk; it's a real one. As those who know far more than we do about the situation have pointed out, the EU's weak sisters are not facing a mere liquidity crisis, but a solvency crisis. It seems that a restructuring is virtually inevitable, causing severe damage to a number of major European banks. Furthermore, the EU will be lucky if the restructurings are limited to Greece, Ireland and Portugal without spreading further.
5) China is battling against soaring inflation even on the officially suspect government numbers. It has steadily raised interest rates and reserve requirements over the last six months in an attempt to slow down the economy. Although the pundits, as usual, are looking for a so-called soft landing, the vast majority of government attempts to slow down an economy result in recessions. This would have a major impact on the global economy including the commodities markets, emerging market suppliers and multinational corporations.
6) The Japanese earthquake is yet another headwind to the economy. In addition to being a severe blow to the Japanese economy, it is having an important impact on the global supply train. Since the quake occurred late in the first quarter, it is likely to have a far greater impact in the current quarter. Indeed, part of the renewed jump in initial unemployment claims may be due to the quake. We'll find out more when companies start to give warnings about second quarter results.
7) The Mid-East turmoil is continuing and is showing no sign of slowing down. Although the eventual outcome is unpredictable and can go in any direction, it is not likely to be conducive to further risk-taking in the markets.
8) The economic recovery appears unsustainable without additional government stimulus, which is politically off the table. Household savings rates have to move higher in order to deleverage debt at a time when only reduced savings rates can induce stronger consumer spending. Home foreclosures in the pipeline are enormous. This will add to already bloated inventories and sink home prices by another 15% to 20%. Almost a quarter of all homes with mortgages are underwater, and this number will rise more as prices drop.
All in all, both fundamental and technical factors point to a coming major decline in stock prices at a time when the majority is still bullish and---contrary to conventional wisdom--- market valuations are historically high.