Tuesday/Thursday Market Commentary

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Different Positions about the Federal Reserve's Policies
9/04/14 7:00 AM


Many sophisticated institutional investors are in a camp that believes the Fed is behind the curve and if they don’t raise rates soon we will have a high probability of entering a period of either bad inflation, or possibly even hyper-inflation.  Other camps are supportive of the Fed’s policies in varying degrees. 

The example used by the first camp shows that if an economist was on Mars over the past 5 years and landed in this country, he would see that we had a decent recovery with the unemployment rate down to 6.2% (almost full- employment). The rate declined from 10% in October 2009 to 6.2% presently, and inflation, based on the CPI, of over 2%.  He would not believe that the interest rates controlled by the Fed (or Fed Funds Rate) would still be at 0 to 0.25%.  He would have thought that the Fed is so far behind the curve that, by the time they started raising rates, inflation would be “out of control”.

Another camp believes that the Fed is using the correct policy of not raising rates because half of the countries in the world are either in a recession or about to enter into a recession.  Witness Japan with negative GDP of 6.8%, Italy that just entered their third recession, Germany and France about to enter a recession, almost all of South America already in recessions, and China’s recent debt contraction and real estate over building will drive them into a major slowdown or crash.  Even though the U.S. was in the best shape of the developed countries we would not be able to “go it alone”.  And if the Fed raised rates we would be in even more trouble than the other developed countries.

We, at Comstock, believe that the excess debt, not only in the U.S. but globally will drive developed countries into a deflationary scenario that could be worse than the “great recession” we experienced in 2007, 2008, and 2009.  We see the decline in commodities (corn, soybeans, hogs, sugar, copper, energy, and even precious metals), and the decline in interest rates throughout the globe to signal deflationary forces at work.  We have been worried about this for some time using the “cycle of deflation” (attached) to make our point.  The cycle is still stuck in the competitive devaluation of currencies segment.  We have used this chart many times in these comments that show the effect of over indebtedness just like the U.S. in 1929 and Japan in 1989.  We wrote the “special report” called “Inflation vs. Deflation” in June of this year.  We sincerely wish to be wrong about this, but that is our position!

A piece written just this week by the St. Louis Fed confirms our opinion and goes into the same reasoning we used in the June report.  Their report is called “What Does Money Velocity Tell Us about Low Inflation in the U.S.”? It shows why the U.S. consumer is hoarding money instead of spending it and generating the inflation that is normally caused by the typical money printing by the Fed.  They explain that the reason for hoarding instead of spending lies in a combination of two issues: 1. A looming economy after the financial crisis.  2. The dramatic decrease in interest rates that has forced   investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds.  In this regard, the unconventional monetary policy has reinforced the recession by stimulating the private sector’s money demand through pursuing an excessively low interest rate policy. (i.e., the zero-interest rate policy).  In this same piece, just published, they show why increasing the monetary base is not increasing inflation because “money velocity” is declining dramatically.  They state, as we did in “Inflation vs. Deflation”, “if the money velocity declines rapidly during an expansionary monetary policy period, it can offset the increase in money supply and even lead to deflation instead of inflation” (see attachment). 

Finally, we have some support from the "main stream" for our “cycle of deflation” coming from the well-respected St. Louis Federal Reserve.    

This is What Happens When the Fed Tightens!
When Rates Rise, After Enormous Easing, It Ends Ugly!
7/31/14 9:30 PM


We know we just changed our comments to the first Thursday of every month rather than each Thursday.  However, we thought it might make sense to write this comment since we have been discussing what would happen when the Fed’s monetary ease comes to a halt.


The financial press and media were at first concerned about the Portugal, Argentina, and Ukraine problems as well as the Russian sanctions, but the overriding problem was the potential for reversing the monetary easing.  We had a taste of the Fed possibly raising rates a little earlier than expected when the Employment Cost Index rose 0.7% for the second quarter.  This was the largest increase for the past 6 years.  After this was released the Dow Jones Industrials erased all the gains for the year by dropping over 300 points.  We have consistently warned our readers about the ramifications of the unwinding of the Fed’s loose monetary policies of the past few years.


In fact, we just wrote on June 19th, “What Happens When the Fed Unwinds Their Balance Sheet?”  In it we stated, “The Fed has tried to stop QE strategies before but were unsuccessful.  During the first two QE programs, they set a date when the programs would end.  Once those dates were announced, the markets began to unravel which resulted in the Fed starting another QE.  They essentially had to start a new QE in order to keep the “wealth effect” alive.  Apparently, they noticed that stopping their programs at a specific date was not working, so they came up with the idea of getting out gradually (tapering) as if no one will notice and everything will go back to normal.”  We also stated, “However, we believe the market will correct significantly before the Fed ends the tapering of the bond purchases.”  We also stated that if and when the market corrects, the Fed may change course and start another QE. 


For all the people that believe the Fed is omnipotent, you have to keep in mind that the Fed did not see the bubble that they were causing in housing all through 2003, 2004, 2005, 2006, and 2007 when they lowered Fed Funds to 1% in June of 2003 and kept it there for a year.  They also watched as banks and mortgage companies enticed every American with a heartbeat to buy homes they couldn’t afford.  The Fed had to use loose monetary policy after the housing bubble burst, but they still never believed that they caused the bubble in the first place.  Remember Greenspan proclaiming that it is impossible to recognize a bubble until it bursts—remember Greenspan had the control of the Fed throughout 2003, 2004, and 2005.    


The problem with what the Fed is doing now, is that they have taken the policies that were needed in 2009 with QE-1, 2010 with QE-2, and started the latest QE-3 that was driven by bond purchases, and no ending time limit (this is why it was called “QE to Infinity”).  The problem with what the Fed has done is that they have taken the policies needed with “QE to infinity” is that it got out of control by expanding the Fed’s balance sheet from $800 billion to $4.4 trillion while keeping the Fed Funds rate at close to zero.  The negative stock market’s reactions to the unwinding of their balance sheet, or even just any indication of rising interest rates will be a problem for the stock market.  Now, every time there is any indication of the Fed raising interest rates or the unwinding of their balance sheet, we believe the ending of this excessive monetary policy will be ugly!

Why Cyclically-Smoothed Earnings Make Sense
7/10/14 7:30 PM



Almost all professional investors look at the P/E ratio of the stock market, but rather than smoothing the earnings as we do, they look at either the past 12 months of earnings or the estimates of earnings over the next year.  We can’t believe how many sophisticated investors use the P/E ratio based on the past year or following year.  The reason we attempt to smooth the earnings is to dampen the volatility that one year of earnings has had over the past decades.  This will make it easier to make longer term decisions.    

An example of the volatility of one year of earnings over the past 14 years would be that “reported earnings” (or GAAP—Generally Accepted Accounting Principles) were $50.00 in 2000, $24.69 in 2001 and came back to $48.74 in 2004.  The earnings “estimates” over that period of time also had tremendous volatility and it boiled down to almost a guess.  So how could you possibly base an intelligent investment decision during that time?  Also earnings were $66.18 in 2007, $14.88 in 2008, and $50.97 in 2009.  Earnings are among the most mean-reverting statistics in investing, and therefore there has to be a better way of determining the “true” earnings.  Earnings always return to the trend and the long term trend of earnings growth over time has consistently averaged about 6% despite the year-to-year volatility.

The idea of smoothing earnings over a period of more than a single year was first proposed by Graham and Dodd in their classic book “Security Analysis” published in the early 1930’s.  Cyclically—smoothed earnings have proven to be a much more accurate predictor of long-term market returns than any method that uses earnings over the past year or following year.  In fact, we used this method in late 1999 when we published a report forecasting that the normalized S&P 500 would be about 1260 ten years from then.  That was significantly below the then prevailing price.  It was a projection we made near the peak of the dot-com bubble.  Almost everybody thought the forecast was crazy although it eventually proved to be highly accurate.

What we do to smooth reported S&P 500 earnings over a longer period of time is to calculate an average of the past 9 years (which usually includes at least one and often two business cycles) .  We then take that average of the 9 years and place it in the 5th year, the exact mid-point of the 9 years.  We then increase that number by 6% per year to the last of the nine-year period and use that number as our normalized earnings for the most current period.  Using that method our normalized earnings for the 12 months ended March 2014 is $90. Then we divide the S&P 500 level of 1970 by the normalized earnings of $89 and come up with a PE of about 22..  This represents a very expensive level for the stock market, and was exceeded only in 1929, 2000 and 2007. 

There are others in the investment community that also normalizes earnings such as Robert Shiller, John Hussman, and Ned Davis.  They each actually use a longer time frame than we do, but each of them comes to the same conclusion that the stock market with normalized earnings is expensive and overvalued. 

Note: From this point, we will issue our comments on the first Thursday of every month, rather than every Thursday, although we may sometimes do additional commentary when it is appropriate.



Happy July 4th Weekend
7/03/14 12:30 PM

There will be no comment this week.  We wish all of our readers a happy July 4th weekend.

The Fed's New GDP Forecast Is Already Badly Out of Date
6/26/14 5:30 PM



In the last several years the Fed has been overly optimistic about economic growth prospects. Fed officials have had to repeatedly mark down their forecast and then revise down the initial and subsequent readings.  In fact, yesterday the real GDP for the first quarter of 2014 was revised down to -2.9% from -1.8% recently, and -1.0% in April of this year.   This is the lowest real GDP reading in 5 years. The consumption segment (by far the largest) was reduced from the original forecast of 3.1% to just 1% yesterday.  This latest release lacked both consumption and capital expenditures

Moreover, with the release of the report for 1st quarter GDP, the Fed’s new downwardly revised forecast for the year, issued only last week, is already badly out of date.  The latest Fed GDP forecast for 2014 is for a central tendency of +2.1% to +2.3% growth.  However, given the 1st quarter growth, a simple arithmetical calculation shows that GDP would have to grow at an annualized rate of about 4.4% for each of the next three quarters to reach its new projection.  We regard this as highly improbable, and are surprised that we have not seen or heard anyone comment on this.   

To get significant growth we need more consumer spending  in order to offset the weak capital expenditures by most of corporate America.  We have discussed the consumption problem in many of our comments.  The largest problem with consumer spending is the enormous debt taken on by the household sector during the period of the mid-1980s to 2007 when the “great recession” hit.  The percentage of household debt as a percentage of both GDP and personal disposable income more than doubled over that period of time.  Since 2007 the consumer has been paying down the debt and deleveraging.  To get good growth we need the deleveraging to end or wages to rise in order to turn around the weakness in consumption.

After 5 years into a recovery real consumption has been growing at only 2% in real terms while the long-term average is closer to 3.5%.  If the deleveraging slows down it will all come down to wages increasing.  While job growth has been barely satisfactory over the past 5 months, and the unemployment rate has declined, the lack of wage growth and a declining Labor Force Participation Rate  to multi decade lows (back to1978 levels), have reinforced the fact that there is still a lot of spare capacity.  We believe, the continued household leverage and spare job capacity will continue to disappoint the Fed and probably force them to reinstate the QE-3 before the tapering ends.

In fact, last week’s comment summarizes our QE point of view with the following statement--  “However, we believe the market will correct significantly before the Fed ends the tapering of the bond purchases and this will result in a delay of further tapering, and maybe even reverse the tapering altogether, and actually increase the amount of bond purchases made each month.  What will be interesting is how the markets handle it.  Will investors continue to believe the Fed will bail the markets out again by buying more bonds?  And will investors go back to the buying of risky assets on the news of more QE purchases, or will they start losing confidence in these policies?  Eventually, we believe it will be the latter”. 


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