Comstock Partners, Inc.January 06, 2011
The Market is Out On a Limb
Despite a $4 trillion increase in government liabilities in 27 months and the unprecedented amount of quantitative easing we still have a tepid recovery, a 9.8% unemployment rate, a faltering housing market and, now, rising interest rates as well. The strong stock market rally since August is not based on organic self-sustaining economic growth, but on faith in the Fed to pump up asset values and implicitly guarantee that no large institution would fail. For the third time in 11 years the market once again is riding an unsustainable wave of speculation leading to overvaluation and investor sentiment as overwhelmingly bullish as at the October 2007 peak.
Both the economy and stock market are likely to run into trouble in the period ahead. Even with massive stimulation this has been by far the weakest recovery in post-war history with most major economic indicators barely reaching or still significantly under their previous cyclical highs. For instance the highly touted increase in holiday sales have only brought chain store sales back the levels reached over four years earlier.
Looking ahead it is highly unlikely that fiscal stimulation can get any more expansionary that it already is, while in the current political climate, the Fed will be under great pressure not to extend quantitative easing any further. If anything the pressure from the new Congress will be to cut spending and resist any increase in the debt ceiling, an issue that is likely to generate negative headline news even in the absence of any action. As the effects of the stimulus wears off the economy will be unable to generate any significant growth on its own.
Consumer spending will be restrained by the high unemployment rate, lack of new hiring, minimal increases in wages and tight credit. As if that weren't enough the latest round of quantitative easing has had the effect of driving up commodity costs, mortgage rates and gasoline. We doubt that this is what the Fed had in mind when it instituted the policy. In addition housing is facing a huge backlog of foreclosures that will drive down home prices and impair household net worth. It will also put millions of more homes underwater on their mortgages, putting more pressure on banks' balance sheets and on Fanny and Freddie (read taxpayers).
Events overseas are also not likely to be market friendly. European policy makers have been unable to come up with a lasting solution to their sovereign debt crisis. We now understand that deposits are fleeing the Irish banks, a possibly important harbinger of future bank runs throughout the Eurozone. Any long-term solution will be highly negative for EU economic growth. That's the problem that the authorities have been reluctant to face as they attempt to paper over every crisis with so-called solutions that can only be temporary until the crisis breaks out again. We note that 25% of U.S. exports are to the EU.
The other big overseas problem is China where the government has made tentative moves to tighten credit to stop rising inflation and an unsustainable housing boom. Chinese authorities are highly concerned about both inflation and housing but are reluctant to bring the economy down and create unemployment and social unrest. As we know from history there is an extremely fine line between doing too much and doing to little when it comes to dampening inflation through monetary policy.
In the face of all these problems the S&P 500 has risen a robust 91% since March 2009 and 22% since August. The market is now overvalued, overextended and overbought. Investor sentiment is now back at the bullish levels reached at the market peak in October 2007 according to the Investor's Intelligence Survey, the AAII survey and equity mutual fund cash levels. In addition momentum has been slowing with both upside volume and daily new highs declining. At these levels the risks far outweigh the rewards.