Comstock Partners, Inc.December 09, 2010
Market Still Facing Major Risks
The deal between President Obama and the Republican congressional leadership is not likely to have a significant positive effect on an economy facing severe headwinds pulling in a negative direction. The key fact to remember is that we are in an economic recovery that will remain restrained by the after-effects of a major credit crisis and the need to deleverage the enormous household debt built up during the boom. As was true for the original stimulus package, any additional spending occurring as a result of the compromise will be temporary with no sustainable follow-through once the stimulus wears off. And while the possible blip in growth is temporary, the addition to the deficit created by the package will remain with us for a long time. In the following paragraphs we cite the severe headwinds creating a drag on economic growth.
1) First and foremost is the explosion of household debt over the last 45 years, particularly the last ten. As a percentage of GDP, household debt went from 45% to 68% in the 35 years between 1965 and 2000, and then soared to 98% over the next nine years to its peak in 2009. Since the deleveraging process started the percentage dropped to 91% by September 30th. In our view the deleveraging has a long way to go. Just to get back to the level reached in 2000 (which itself was historically high), household debt would have to decline by $3.4 trillion. Since this amounts to a full 32% of personal consumer expenditures, it's easy to see why the debt has been and will continue to be such a drag on the consumer.
2) No sustainable economic expansion has ever taken place without a strong boost from the housing sector, and this is not likely to happen anytime soon. Sales of both new and existing homes are slogging along at the bottom and prices are dropping. Inventories remain exceedingly high while the backlog of coming foreclosures is huge. If anything the new compromise package has caused mortgage interest rates to rise, putting even more of a burden on the beleaguered industry. Furthermore the mess regarding the unconstitutional (due process anyone?) legal shortcuts taken in efforts to foreclose on delinquent mortgages will be difficult to untangle and could end up getting banks in a lot of legal and financial trouble.
3) States and local governments remain in bad shape with large budget deficits leading to spending cutbacks, layoff and higher taxes. This is another potential crisis in the making in the period ahead.
4) Monetary policy is essentially impotent in the current crisis. The Fed has used all of its conventional weapons and is left with untried and untested weapons with potential unintended and unknown consequences.
5) Banks went into the 2008 credit crisis loaded with toxic assets, and, to a large extent, they still have them. While TARP was originally proposed by Treasury Secretary Paulson as a buyout of toxic assets, the program was almost immediately changed to a generalized bailout. The accounting rule-makers were then pressured to do away with mark-to-market accounting, thereby papering over the problem and leaving most of the toxic assets on the banks' books, where they remain today. This is one of the reasons banks are hoarding cash and are so reluctant to lend. They know what they have.
6) Sovereign debt is another problem that has not been dealt with, and therefore doesn't go away. While the Ireland and Portugal situations may temporarily be papered over, a number of weaker EU nations are essentially insolvent and will eventually need to have their debts restructured with severe damage to the European banks that hold their debt. This will continue to be a drag on economic growth in the EU.
7) With inflation threatening to get out of control Chinese authorities are trying to tighten monetary policy gradually to engender a soft landing. With the leading economies of the U.S., the Eurozone and Japan in such weak condition, China has been a major catalyst for global growth. Any substantial slowdown in China would therefore have a serious impact on global growth.
The stock market has recently gotten everything it wanted----QE2, no expiration of tax cuts, additional stimulus and strong earnings reports. Still the S&P 500 is about where it was in April and has made no progress in over a month. Although the market can still break to the upside, the move off the March 2009 bottom has discounted a lot of good news while ignoring all the real pitfalls that may be ahead. In addition the market is substantially overvalued at 18 times smoothed trendline S&P 500 earnings. At this point we believe the downside risks far outweigh the potential upside rewards