Comstock Partners, Inc.June 17, 2010
Why it's Still A Secular Bear Market
In our view the stock market is in a secular (long-term) downtrend that began in early 2000 and still has some time to go. The collapse in the dot-com bubble (2000-2003) gave way to the historical housing bubble that itself collapsed in 2007, leaving the U.S and the world awash in enormous debt, huge overcapacity and overvalued markets. The deleveraging of this debt and its negative consequences for the economy will create serious headwinds for the stock market for a long time to come.
The current debt crisis cannot be solved by mere declarations from official authorities. The debt crisis began with the decline of the housing market in 2006 and is continuing to this day. Phase I involved the transfer of private debt to sovereign debt by means of massive monetary and fiscal stimulus that has led to statistical economic recovery that remains anemic by historical standards. The problems that emerged with the Dubai crisis heralded the beginning of a sovereign debt crisis and phase ll---the transfer of weak sovereign debt to relatively stronger sovereign debt. The problem is that total debt is not reduced, but keeps getting shifted from weaker to stronger entities. Overall debt is too huge to ever be paid off and the relatively stronger nations will run out of ammunition long before the crisis is resolved.
The only long-term solution is a deleveraging of global debt, a process that cannot be solved with a magic wand waved by central bankers and prime ministers. It is a process that will take many years and will be accompanied by slow growth, numerous recessions and financial turmoil. The weaker European nations are already going on austerity, and there is more to come. Greece will have to undergo severe budget cuts without the benefit of an independent monetary policy or the ability to devalue its currency. Spain is cutting its budget by $18 billion and Italy by $15 billion. The UK, too, had announced major reductions in healthcare, IT and civil service. Germany's plan to aid the southern EU nations and to slash its own fiscal deficit has threatened to bring down its governing coalition. France has proposed increasing its retirement age, leading to protests in the streets. The new austerity throughout Europe will lead to a sharp slowdown or recession in with negative implications for the rest of the world at a time when the U.S. economy is still fragile and China is trying to restrain a major housing boom. The entire globe is in danger of becoming like Japan, which is still struggling after two decades of monetary and fiscal stimulus---and Japan was operating within a global economy that was still robust during most of its time of trouble.
As for the economy, the general impression that the U.S. is undergoing a normal recovery is highly misleading. The following outlines a number of key economic series that supports our case that the rebound has actually been quite weak.
1) While May retail sales were up 8% from the early 2009 low they are still 4.4% below the peak reached 2 1/2 years ago in November 2007. By way of comparison, over the last 43 years retail sales have seldom declined at all, even in recessions.
2) May industrial production (IP) was 8.1%% over its June 2009 trough, but still 7.9% below the late 2007 peak. At its current level, IP is still where it was over 10 years ago in early 2000.. Never since the 1930's depression has IP failed to exceed a level attained 10 years earlier.
3) New orders for durable goods in April were up 21% from the low of March 2009, but still 22% below the top in December 2007. In fact new orders are at the same level as in late 1999, over ten years ago.
4) Initial weekly unemployment claims steadily declined from 651,000 in March 2009 to 477,000 by Mid-November, but have been range-bound with no improvement in the last 6 ½ months. Furthermore the current number of claims is still in recession territory.
5) April new home sales were up 14.8% from a month earlier and are up a seemingly robust 48% since the low. However, the current number is still a whopping 64% below the 2005 monthly peak. Prior to the current recession the last time new home sales were this low was in February 1991.
6) Existing home sales in April were up 27% from the low in late 2008, but still 20% below the peak in late 2005. We also note that both new and existing home sales were boosted by the homebuyers tax credit that has already expired, and that the housing market has weakened considerably since that time.
7) May vehicle sales of 11.6 million annualized were up 14% over the prior month and 26% from the trough. However, this remains far below the annual average of about 16 million vehicles in the decade starting 1997.
8) Personal income for April was up 3.2% from the May 2008 trough with major help from government transfer payments, but is still 0.8% below the peak about two years earlier. We note that prior to the current cycle, personal income was never down year-over-year in any month going back to 1960, and the current figure of plus 2.5% is still at recessionary levels. .
9) Payroll employment in May increased 431,000, but the vast majority of these were government census jobs. Private employment was up only 41,000, leaving the total number of employed still 7.4 million jobs below the pre-recessionary peak. In fact, on a point-to-point basis no new jobs have been added since January 2000.
10) March consumer credit outstanding was 3.4% below a year earlier, the 13th consecutive monthly decline. Prior to the current recession, consumer credit had never been down from a year earlier in any month since the waning days of World War II.
The data cited here cover the major indicators of economic activity, and they paint a picture of an economy that has moved up, but only from extremely depressed numbers to a point where they are less depressed. And keep in mind that this is the result of the most massive monetary and fiscal stimulus ever applied to a major economy. In our view the ability of the economy to undergo a sustained recovery without continued massive help is still questionable.
Although the majority assumes that the housing market has already bottomed, a second wave of decline is already underway. Recent housing numbers have mostly been bolstered by the home buyers' tax credit that expired on April 30th, the date when contracts had to be signed to qualify. Sales, however, are not recorded until closing, which has to take place by June 30th. Sales of new and existing houses may therefore show some further strength until then, but fade after that time.
The point we're getting to is that sales already appear to have declined significantly after the tax credit expiration. New home sales, existing home sales and housing starts are all soft. In addition the Mortgage Bankers Association (MBA) purchase application index, probably the best leading indicator of future home sales is down about 40% since the April 30th tax credit expiration, and is now at a level not seen since 1996.
All of the evidence we see indicates that the tax credit merely pushed home sales ahead, and that without it, sales and prices will resume their decline. In addition to the lack of tax credits, adjustable rate mortgage resets will soar from about now until November and then reach an even higher peak in 2011. This will put more and more mortgage holders into a position where they can longer meet their monthly payments, leading to another round of defaults and foreclosures.
Furthermore, delinquencies were climbing even before the rise in resets. According to the MBA, 1st quarter delinquencies surged to a record in every single category---fixed prime, adjustable prime, fixed subprime and adjustable subprime. At the end of the quarter fully 10% of all prime and 27% of all subprime mortgages were in delinquency.
Another big problem for the industry is the so-called "shadow" inventory, consisting of homes that banks are holding, but haven't foreclosed; homes that have been foreclosed, but not put on the market; and delinquent homeowners who have not yet foreclosed. We should also mention that 14.9 million homeowners owe more on their homes than the homes are worth, fully one-third of all U.S. mortgage holders. Of these, 9% are more than 20% underwater. Many of these homeowners may walk away from their homes even if they are capable of making their payments, and many already have done so. Some reputable studies have estimated that one-quarter of all defaults is caused solely by negative equity.
The prospect of declining home sales and prices has dire consequences for the economy. The further drop in prices will put even more mortgage holders underwater and exacerbate the number of subsequent defaults and foreclosures. The resulting decline in consumer net worth feeds back into lower consumer spending and sets up a negative feedback loop that works its way through the economy. Furthermore the drop in home values sharply reduces the value of the mortgages held by the banking system. Although the suspension of mark-to-market regulations means that banks won't be forced to write down the loans, bank managements will certainly be fully aware of the potential threat to their capital, and be even more reluctant to make loans than they are today.
In that kind of financial and economic climate it is hard to conclude that the stock market is cheap or oversold. Most major stock market bottoms have occurred with the S&P 500 selling at 20% or more under its 200-day moving average. The index sold at 28% under its 200-day average at the 2002 bottom and 38% under at the 2009 bottom. Even at the recent lows the market was only 6% under its 200-day average. In addition sentiment is nowhere near as gloomy as it usually gets at major lows.
Valuation metrics, too, do not indicate that investors are really fearful at current levels with the S&P 500 selling at slightly over 17 times trailing smoothed reported earnings. At major past market bottoms the P/E was below 10. In fact the P/E was below 10 on trendline earnings at some point in 17 of the last 60 years going back to 1950. If anything, the current P/E is more indicative of complacency rather than fear. As we have stated many times "it's all about debt" and the deleveraging process has a long way to go. We are therefore maintaining out bearish position on the market.