Tuesday/Thursday Market Commentary

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We have been warning our viewers since 1999 about the word “deflation”, and the negative stock market action when the deflation occurs.  In fact, we authored the chart, “Cycle of Deflation” (first attachment) which shows the flow of the typical deflation.  The deflation starts with excess debt and over-investment leading to excess capacity and weakness in pricing power.  This leads to the devaluation of the countries’ currency.  When that starts to affect exports the deflationary country typically gets into a “currency war” with its’ trading partners.  This competitive devaluation leads to protectionism and tariffs followed by “beggar-thy-neighbor”, where countries affected by deflation resort to selling goods and services below cost in order to keep their plants open.  As you can see this is a vicious cycle that eventually leads to plant closings and debt defaults until pricing power returns. 

 The full effect of this deflation has not really permeated the USA, but you can see many indicators point to more deflation.  The U.S. has not experienced serious deflation since the “great depression” but we can use the example of the deflation that took place and is still taking place in Japan.  Their deflation started in 1989 and has continued for the past 26 years.  Their currency (the Japanese Yen) started declining as far back as the early 1980’s as their debt accelerated sharply. 

As you can see in the second attachment (Total Credit Market Debt as a % of GDP) the U.S. total debt started accelerating sharply from 155 % of GDP in 1981 to 367% at the peak in 2009, and is still staying at an incredibly high percentage of 334% of GDP.  Keep in mind that the total debt to GDP was 260% just before the “great depression” and troughed at 130% in 1953. As stated previously, the U.S. debt to GDP peaked at 367% and if we were to follow the path of the “great depression” the U.S. debt would decline from $60 tn to about $30 tn after the unwinding of the debt we expect will continue to decline for years following the compounding of total debt for the past 35 years. This kind of excess debt is responsible for the anemic recovery in the economy and stagnate wages over the past 15 years.   

Commodities are clearly the “canary in the coal mine” as far as deflation is concerned.  Remember when we first talked about this in 1999, (Windows Word) never heard of deflation and kept trying to correct us by stating, “do you mean inflation?”  Now, the world is concerned about almost every commodity on earth declining in sync with each other.  Ever since Saudi Arabia announced last fall that they will not decrease oil production to support crude oil prices, the price of crude has plummeted.  The concurrent economic slowdown in China has exacerbated this decline not only for oil but also most other industrial commodities.  Zinc, lead, copper, nickel, aluminum, precious metals and many more commodities are breaking through technical support areas that have held up for years.  Actually the CRB Raw Industrial Spot Index (Chart 3 from our best data resource Ned Davis Research—middle chart) represents these metals as well as many more commodities.  Since we started warning our viewers about the impact of deflation the CRB had some major declines and rebounds as the Fed pumped in a flood of money to try to prevent the inevitable deflation as the debt continues to decline.  This index peaked about 1998 as the dot com bubble was about to burst and declined to the 220 area in 2002 (that also troughed after the 1987 stock market crash).  Then the Fed dropped the Fed Funds Rate to 1% in 2003 and kept it there for a year.  This started the housing bubble which was made worse when sub-prime loans exploded as Alan Greenspan encouraged banks and mortgage companies to make these loans (and put his blessing on the home price frenzy).  The peak of the housing market in 2010 coincided with the next peak in the CRB at 610.  The CRB has declined to 440 presently from 610 and it is our opinion that this decline will continue down below the trough of 310 in 2009 and the 220 trough that occurred in 2002 and 1987. 

Another key to the deflationary scenario we anticipate is the velocity of money (chart 4-the personal income divided by M2) declining substantially from 2000 as the dot com bubble burst to 2003 when the Fed lowered rates to 1%.  It was 180 at the 2000 peak and 159 at the 2003 trough.  It rose to 168 in 2007 at the housing peak before declining to 144 in 2009.  It rose for a year to 147 in 2010 before declining to 127 presently.  The velocity of money is measured by the number of dollars spent to buy goods and services per unit of time.  In other words, it is the measurement of money circulating sharply when it is rising and not circulating as much if it is declining.  We expect it to continue declining as consumers and businesses will not be making transactions as frequently as they have in the past. 

We are very surprised that the stock market has held up so well with this pending deflation overhang, however, it is trading in a range that we believe will break out to the downside.  The trading range for the S&P 500 is 2135 resistance, 2040 is support, and the 200 day moving average is 2072.  The trading range for the DJIA is 18,352 resistance, 17,036 support, and the trading range for the NASDAQ is 5233 resistance, and 4900 support.  The S&P 500 is now is 2083, the DJIA is 17,410, and the NASDAQ is 5056. 



The Fed Continues to Project Weak Growth
Happy Fourth of July
7/02/15 8:30 AM

To say the least, the Fed’s own projections of GDP growth continue anemic at best.  For 2015 the Fed now projects 1.9% growth in GDP followed by 2.55% in 2016 and 2.3% in 2017.  We have stated many times that the recovery since the bursting of the “Housing Bubble” is the most tepid recovery since the great depression and as you can see, the Fed is forecasting more of the same.  We have also stated that the primary reason for this is that debt, i.e., government, corporate, household and student loans, are eating us alive.  At the same time, the Fed is predicting relatively “full employment” with an unemployment rate of 5% starting in 2016.  It turns out that the only way to get to a 5% unemployment rate is to eliminate those people that were not able to find work and have given up from the equation.  Our analogy here is to say the Fed is like the golfer that gives himself every putt over 20 feet and then tells everyone he’s “scratch”.  It is not reality!


From time to time, however, there are bright spots that seemingly appear.  One such spot is automobile and truck sales that were very strong in June.  It turns out that those sales were achieved through a record percentage of leases and/or record length car loans.  Said another way, debt is the reason that auto sales were good.  We therefore do not believe this is a “turn for the better”.


If we are wrong, the Fed will have to raise interest rates sooner and faster than the market expects.  If we are right, the economy will continue to grow at somewhere between anemic or even negative rates.  Either way, stocks by almost any valuation measure are expensive and when that is the case the forward rate of return suffers; it always has throughout history and we expect it will now.  This is why we remain so bearish on U.S. equities! 


We would like to wish all of our viewers a happy and safe 4th of July!

The Federal Reserve has Painted Itself into a Corner
And There is not Much Room for the Stock Market
6/02/15 3:00 PM

The Federal Reserve has Painted Itself into a Corner


The Federal Reserve seems to have solved the problem of extricating the U.S. from the terrible “great recession” by employing three major monetary policies.  They started with a “zero interest rate policy (ZIRP) for the past 6 years, and then used three Quantitative Easing’s to build-up the Fed’s balance sheet from $800 billion (bn) to almost $4.5 trillion (tn).  We however, believe that the Fed’s actions will result in an even greater set of economic problems in the near future. 


To support our view we will examine various economic data.  We will attempt to go through the various economic data that have just recently been released and show that the U.S. economy is decelerating, even after the loose monetary conditions over the past 6 years.  However, we believe that even if the economic data improves, that will only allow the Fed to raise rates at the same time as other major economies (Japan, Euro Zone, and China) across the globe are in the process of copying the same policies we have used for the past 6 years as they reduce rates and lower the value of their currencies.  Finally, we will conclude with a view of our familiar Cycle of Deflation chart to demonstrate where we currently are positioned in the cycle: “competitive devaluations” which is essentially the same as “currency wars” (see attachment). 


GDP growth in the U.S. after 6 years of “off the charts” Fed monetary easing is the slowest recovery on record since World War II.  And just recently the deceleration in economic data has increased.  There is deceleration in corporate earnings, capital expenditures, economic growth, consumer confidence, and Federal Reserve monetary easing.  The reason for the slow recovery is the exact same problem that got us into the mess during the “great depression”.   It all boils down to too much debt and until the excessive debt is worked down the U.S. economy will struggle with the recovery (see attached chart). 


Some of this can be explained by the severe winter weather, the west coast port closings, and the U.S. dollar increasing.  Due to these transitory problems, most investors and economists believe that there will be a rebound from the first quarter’s negative GDP report.  In fact, they are especially optimistic since the decline in energy prices should be expected to increase consumer spending.


However, American consumers are not spending their gasoline savings, but instead are spending and saving at recession levels.  April consumption was unchanged, March was up 1.1%, February was up 0.6%, January up 0.85%, and December up 0.9%.  These are extremely low consumption levels and consumers have continually increased their savings rate from 4.7% in early 2013 to 5.6% presently. Clearly, the U.S. consumer is acting the same way they did after the “Great Depression” as they were afraid to consume and attempted to save as much as possible.  We believe that this will continue because economists cannot anticipate “consumer behavior”, and when the consumer is concerned about another financial crisis like they just experienced in 2007 (and even in 2000) there is nothing that will stoke their spending except time and debt reduction. Despite common lore, economists as a whole do not have a great record when it comes to predictions.  Recall that in early 2015, polls taken of economists showed unanimous opinion that interest rates in the U.S. would rise.  Of course they fell!! So we take no solace that economists currently predict an acceleration of growth. 


To make things worse the U.S. dollar has reversed the latest 5 year decline from 2009 to 2014.  This will not just hurt the U.S. multinational companies from exporting goods and services to our trading partners, but will also accelerate the “Cycle of Deflation” deflationary conditions compared to Japan, Europe, and China. 


We believe that the economic conditions are bad and will only get worse.  If this is correct, we believe investors in this country will conclude that the Fed’s policies were not as constructive as the world believed, and will act the same way as the U.S. consumer by seeking safety in their investments (said another way –would sell stocks) and act more like the consumer who is not spending but instead saving.


However, if we are incorrect and the first quarter is really a fluke due to transitory conditions, then the Fed will start increasing the Fed Funds rate at the same time our trading partners are lowering their rates.  In our opinion, this will be even more detrimental than the poor economic environment we described above.  So either way it looks to us like the stock market may not perform well this year and probably not for the next few years.     

The Debt, ZIRP, and Valuation

As we write the US stock market, as measured by the S&P 500 and Nasdaq Composite Index, hovers at or near new highs.  We will take this as an opportunity to reiterate that this is a bubble that is the direct creation of the Federal Reserve.  We continue to refer to this phenomenon as the “Central Bank Bubble”.

Just under one year ago, analysts were estimating S&P 500 operating earnings to increase for the first quarter of 2015 by over 10%.  That number is now substantially lower and has gone negative for the entire index.  According to “FactSet Earnings Insight”, both Q1 and Q2 2015 earnings are now expected to be lower.  Through May 1, the blended result of companies that have reported and have yet to report  for Q1 2015 stood at -.4%.  Analysts are in fact expecting year over year declines through Q3 2015 but are then expecting a strong rebound in Q4 2015.  We agree with the former and strongly disagree with the latter. But whether attributed to weather, the west coast port strike, or dollar strength, the fact remains that for whatever the reason, two declining quarters constitutes an “earnings recession”.    We have had 13 “earnings recessions” since 1945, and all but three of those have led to an economic recession.  We continue to believe corporate earnings will not grow as a whole at a meaningfully different rate than US Gross Domestic Product (GDP), as corporate earnings are a proxy for economic growth.   Growth in the economy, in turn, is heavily influenced by “Total Credit Market Debt”, which is the sum of government, corporate and household debt.

Only at the time of the great depression of the 1930’s has “Total Credit Market Debt” been greater than 200% of GDP in the United States (see attached chart from Ned Davis Research)).  That is, of course, until the middle 1980’s when this metric again penetrated that barrier.  After that time it went on an inexorable march to a whopping 367% of GDP just prior to the bursting of the “Housing Bubble” and stood at just under 332% as of the end of 2014.  The level of debt continues to be a headwind to economic growth that will persist until the debt is paid down. 

What has acted to somewhat mask this headwind is, what we believe, is the most reckless policy ever adopted by the Fed.  The Fed was wrong on the “Dot Com Bubble”; was wrong on the “Housing Bubble”; and we believe will be wrong in the creation of the current “Central Bank Bubble”.  This Fed is in a major experimentation mode which is very dangerous.  The policy of which we speak is, of course, Zero Interest Rate policy, or (ZIRP).  This policy has driven the Fed’s Balance Sheet from $800 billion in 2008 to $4.4 trillion currently.

It is because of ZIRP that stocks do not appear, to some, to be expensive.  After all, if the alternative is a 2% ten year treasury or 2.6% thirty year treasury, maybe a 2% dividend yield isn’t so bad; or so the thinking goes.  But as stated above, the growth in corporate profits in the long run is a proxy for the growth in the economy, or GDP.  And right now stocks, measured by market capitalization, are near the highest they have ever been relative to GDP.    Every major market bottom and top has been coincident with very low or very high ratios of “Stock Market Capitalization to GDP”(see attached chart from Ned Davis Research).  It is likely the reason is that this metric has purported to be a favorite of Warren Buffet.    In fact, the only time this metric has been higher was just before the” Dot Com Bubble” burst.   It comes at a time when deflation is playing out all over the world.  The dollar is strengthening, which hinders multinational companies from exporting goods abroad.   In addition, it appears that companies do not have enough pricing power to increase margins.

We at Comstock have been telling our viewers that we have been in a deflationary environment for years.  It seems the markets now are agreeing with us as there are currently few countries that are expecting any material inflation over the next ten years.  This is evident by the yields in ten year sovereign paper.  The following are yields as of the date of this writing: United States 2.19%; United Kingdom 1.97%; Italy 1.81%; Spain 1.78%; France .82%; Japan .36%, and Germany .52%.

What all of these countries have in common, in addition to being democracies, is that their respective central banks are in a “Liquidity Trap” situation, where low and even negative interest rates do not encourage consumer spending but rather consumer savings.  Businesses in turn do not have the confidence to invest in new plant and equipment.  This is particularly true in the United States, where the average age of private fixed assets is the oldest in the past fifty years. 

So, to our viewers we say, we have been early on this, as we were with the Dot Com and Housing Bubbles, but we are confident this will end the same way as those bubbles. The US stock market is historically expensive and financial assets have been inflated by an experimental central bank policy.  It is an error that is now being repeated by central banks in Europe, Japan and just recently, China.  These markets are being influenced in similar ways as ours, rather than fiscal and tax policies that would stimulate sustainable growth.   We will hold our view that stocks are expensive until they become priced more reasonably relative to the growth prospects of the economy. We have maintained consistently that high levels of debt are the main problem affecting growth and those debt levels will not be going away any time soon.



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