Comstock Partners, Inc.March 24, 2011
Stock Market In A State Of Denial
Those of you who watch financial TV or read the financial media have probably heard the current market referred to as the "nothing matters" market since it is supposedly ignoring a spate of negative news. According to this view, the negative news is exogenous and temporary while the true backbone of the market is the so-called strengthening recovery that has a long way to go. We have a number of disagreements with this point of view.
First, you may have noticed that the market has not exactly ignored the problems. The S&P 500 peaked about five weeks ago at 1344 and then proceeded to fall 7.1%. It has since climbed back by 4.6% in a rally that looks somewhat anemic by past standards. This type of action is actually typical of the way most bear markets begin. Generally bear markets go through three psychological phases----denial, concern and capitulation. Most often, but not always, the market rallies between each phase. The denial phase is the initial downleg from the bull market high, and we are only at the start of that downleg now.
During the denial phase the majority of investors are still in a bullish frame of mind after seeing continual profits in their account and having seen the market bounce back from prior corrections. They look upon the decline as merely another buying opportunity and think that stocks are cheap. In addition the fundamentals during this period are still perceived as positive and any negative news is downplayed.
Second, we don't regard the negative news as necessarily temporary, and only the tragic Japanese earthquake is truly exogenous. The European sovereign debt problem is a spillover from the massive 2008 credit crisis, and is not going to be resolved anytime soon. When the crisis initially emerged in Greece it was reasonably clear that the problems could spread to Ireland, Portugal and Spain, and, so far, has continued along that path. The Mid-East, North African crisis was always of a matter of "when" rather than "if" and was a recognized risk. It is not going away soon. China is engaged in the high-wire act of attempting to rein in inflation without causing a recession, a feat that historically has had a low chance of success.
It is also far too early to dismiss the Japanese earthquake as a passing phenomenon. We still don't know how this will all play out. With high levels of radiation in the water and farmland of the affected area, we don't know if this will become a "dead zone" for years to come. We have also heard about the possibility of significant global supply disruptions and reduced output that could presage lower demand and scarcities.
Third, the so-called strengthening recovery that supposedly more than offsets all of the above is highly fragile and subject to reversal. The second dip in housing that we have expected is now upon us. House prices are falling and inventories are extremely high while close to a quarter of homes with mortgages are underwater. The further dip in prices will put even more mortgages underwater, leading to even more foreclosures and an undermining of consumer net worth, confidence and spending. Real wages have decreased in four of the last five months and even new orders for durable goods, a precursor for capex, has weakened in the last two months.
In addition let's not overlook the point that QE2, which is pouring about $3.5 billion into the economy every weekday, is due to end on June 30th, and is unlikely to be extended. Both the economy and the market slowed significantly after the conclusion of QE1 and came back only with the announcement of QE2. At that point monetary policy becomes a headwind instead of tailwind at a time when political pressures are reining in fiscal policy as well.
In sum investors are in a state of denial similar to when they denied the dot-com boom was a serious problem in early 2000, or that subprime mortgages were a problem in 2007. This is typical of investor behavior at tops in all publically traded markets over hundreds of years, and human behavior is not likely to suddenly change now.