Regardless of our level of financial sophistication, most of us recognize that we are in the midst of a momentous stock market and economic adjustment process. Our sense is that, through the broad lens of history, the 11 years between 1997 and 2007 will be remembered as an anomaly for both the stock market and the economy. This was an historical accident which culminated in a credit-induced acceleration of the stock market, housing, and phony output. The drastic declines in the years 2000 to 2002 and the past year (2008) in retrospect may be viewed as times when markets attempted to equilibrate.
Governments, the world over, are doing what they believe to be their level best to ameliorate the effects of this return to equilibrium. Whether letting the free markets alleviate the pain and suffering is better than the massive government intervention that is taking place now is debatable. We, at Comstock, remain ambivalent as to whether massive government intervention or free markets are the best answer to the problem. The thing that is not debatable is the fact that the readjustment process will be very painful for the economy and will not end until the housing market gets back to the norm-- and that will take a decline of about 25% from this level (see attached chart by ISI). We do not see anything wrong with the price of homes declining to levels where people can afford them. If this decline in home prices is accomplished by less government intervention it may take less time but will be more painful for our nation. What we don't want to see is the government intervention here working like the Japanese intervention in the 1990s.
We also don't believe that stocks will begin a new bull market until valuations decline to levels reached at bottoms of past secular bear markets. These levels can be seen on the Ned Davis charts shown on the right side of our home page under the title of "Limbo, Limbo". However, since we are trying to be more accommodative to more bullish market observers, we are looking, at best, for the S&P 500 to bottom at about 650 to 700 by using the maximum trough P/E of ten times our trendline reported (GAAP) earnings of about $70. Believe it or not, virtually all of Wall Street is still using the "operating earnings" that we have ridiculed for the past decade. The estimates for 2009 operating earnings started at $112 at the beginning of 2008 are now at about $80 (see attached chart). Even if you are crazy enough to use these operating earnings, the latest estimate multiplied by ten still has the S&P 500 trading at about 800, a target that seems overly generous.
The third requirement we expect to see before this stock market reaches bottom is massive public liquidation of equities and equity mutual funds. The best way to measure this is to monitor the mutual fund liquidations relative to the total amount of money in equity mutual funds. We are monitoring this presently and will do a report at a latter date. We can say that the current cumulative amount of liquidation to date is not sufficient, in our view, to be considered a true capitulation.
So, the bottom line is that we expect the housing market to fall by 25% from here, equity valuations to decline to typical bear market lows, and more liquidation of equities and equity mutual funds by the public before the stock market reaches the significant bear market bottom we expect.
As most of you know, since 2004 we have been predicting a collapse in the housing market and a weak U.S. economy that would spread throughout the globe. We also predicted that the S&P 500 would decline below 700 ever since the bubble of the late 1990s. In early July 2008 we predicted that commodities (including energy) would decline sharply and that the decline would not be positive for equities. Commodities peaked a week later. The last prediction was that "The Cycle of Deflation" chart would enter the competitive devaluation and "beggar-thy-neighbor" policies.
Just a few months ago our government was sure that China would have to do whatever possible to let the renminbi (Chinese Yuan) rise against the dollar in order to be on a "level playing field" with the U.S. When Treasury Secretary, Henry Paulson, visited China the first questions on his return by congress was "did he bring up the inequity of their currency being tied to the dollar, and shouldn't they let the Yuan float to higher levels"?
Now, the subject is rarely discussed. Even as our government expected China to raise interest rates and decouple their currency in order to have their currency drift higher and be more equitable, their currency has drifted lower NOT higher. This trend, in our opinion, will be pervasive. Virtually all of our trading partners have economic problems that they hope will be helped by being able to sell more of their goods and services abroad. But exports are falling off a cliff everywhere and the only temporary solution will be to do whatever possible to lower their currency (competitive devaluations). Next in line will be resorting to "beggar-thy-neighbor" policies, which means that nations will do whatever possible to gain an advantage relative to their trading partners (e.g. tariffs and import duties).
Chinese exports have gone from gains of about 20% in the months of September and October to negative growth of around 2.5% in November and December as trade growth has collapsed as the main pillar of their economy. The major reason for the decline is the fact that the U.S. consumption appetite, that was so voracious in the past has come to a screeching halt. Two other pillars of the Chinese economy, their property market and domestic consumer spending, are also falling off a cliff, which leaves exports as the only way out of their economic doldrums.
This is why China has not raised their interest rates to oblige our government's wishes, but instead has lowered them, without any criticism from our country. The same story could be said about virtually every one of our trading partners. The Euro zone is another prime example of virtually the same problems facing China. The ECB has now reduced rates four times from 4.25% in September to 2% today. The latest reduction occured today when rates were cut 50 basis points as Jean Claude Trichet, ECB Chairman, stated, "Economic risks lie clearly to the downside". The latest cuts came right after Trichet proclaimed that "inflation was the Euro zone's main problem and there are no credit problems with none expected".
Expect to see and hear more about competitive devaluations and "beggar-thy-neighbor" policies throughout the current year.
Thank God for the miracle in the Hudson River.