We try not to get more bearish as the stock market continues to decline, but as the U.S. and world economies continue to implode it is difficult not to do so. However, getting more bearish as the market is getting more attractive makes no sense. Also, the market is very oversold with record negative sentiment in some indicators. This could produce a counter trend rally of as much as 20-25% at any time. We are not saying this because of the market rally this week-we were on Bloomberg TV Monday afternoon and called for the rally at that time (click here to view video http://www.youtube.com/watch?v=HlkPJBapf60). Nevertheless we think that the market has not made a secular bottom. In order for the market to make a solid bottom total private U.S. debt has to unwind, the market has to become more undervalued, massive excess capacity and housing inventories have to be worked off and investors have to capitulate in a last wave of selling.
We still expect the unwinding of $52 trillion of total U.S. debt to continue to produce stress across the U.S. and this will also continue to spread abroad since many foreign economies depend heavily on the U.S. consumer. Even more surprising is the fact that this $52 trillion does not include the present government interventions and stimulus plans nor the Medicare, Medicaid, and Social Security future promises made without any planned funding (estimates are as much as $86 trillion). The unwinding of $52 trillion in debt is extremely onerous since one half of it was generated during the twenty first century alone. And with $26 trillion of debt generated during the last eight years the GDP grew at less than $5 trillion. Therefore, it took $5.40 of debt to generate $1 of GDP---this cannot possibly be sustainable and has to have substantial repercussions on profits and the economy. There is only one country where the numbers are available that is close to the U.S. either in absolute terms or relative to GDP. That country is Japan which has close to $18 trillion of debt on a $5.5 trillion economy-and you are all aware of the problems of Japan, which has now had, not one but TWO lost decades. There is no other country with more than $6 trillion of recorded total debt.
The consequences of the deleveraging of $52 trillion of debt are clearly shown in the attached spread sheets of "reported" and "operating" earnings in 2008 and 2009. Reported S&P 500 (GAAP) earnings are now estimated at only $17 for 2008 and $32 for 2009. "Operating" earnings (which exclude write-offs) estimates have been reduced to $49 for 2008 and $64 for 2009. These are so extreme that we are using a smoothed trendline GAAP earnings estimate of $60 for 2009. In past secular bear markets P/E ratios have bottomed at 8-to-10 times. Therefore, even at trendline earnings of $60 (a generous number) the S&P 500 would bottom at between 500 and 600.
We are also monitoring significant capitulation to determine when the secular bear market could end. We have stated in many past comments that one of the main indicators of capitulation is public liquidation of equities and equity mutual funds. The public will always stay the course until real pain and suffering occur and then panic out of stocks at the wrong time. Past history has shown that it usually takes liquidation of about 10% of total equity mutual funds to start the capitulation phase (both domestic equity funds as well as domestic and foreign equity mutual funds). As you can see from the attached NDR chart (concept by Comstock) the liquidation is still around 6-7%, but if the market continues to decline, it could stretch out to our requirement of a10% liquidation.
The last chart attached is the one we have used many times in the past (housing prices relative to median household income). The reason we are showing this again is because we want to show the point on the way up where we wrote a "special" comment in September of 2003 titled "Real Estate-the Catalyst for the Next Deflationary Bear Market". The thing that amazes us is that if we could see the bubble in real estate in 2003, how could the Fed, Administration, and Treasury Department miss this incredible bubble when we could see it so clearly? In fact, when you carefully look at the chart, almost anyone could see how the move from 2002 to 2006 was clearly a bubble. We understand that the Fed has 225 PhD economists working for them. Doesn't it confound you that the Fed didn't say to just one of their PhDs to be in charge of just monitoring housing or real estate and get back to the Chairman if he or she believed that there is a bubble developing. They could have also had one more PhD in charge of monitoring stocks for a bubble and still had 223 economists doing whatever it is they do now.
In summary, the requirements we are watching to possibly end the secular bear market that started in 2000 are the unwinding of U.S. total debt and valuations of equities to decline to around 10 times earnings (along with other valuations metrics that are listed on our home page under Limbo, Limbo How Low Can it Go). We also expect capitulation by the public discussed above, and a continued decline in housing prices to a minimum of 2.75 times household median income (it is possible to decline to the lows of 2.25 times median income).
This doesn't mean that this counter trend rally couldn't take the market up 20-25% just as were experienced during the typical rallies in most secular bear markets.