Comstock Partners, Inc.March 17, 2011
Comstock’s Macro Viewpoint
Our hearts go out to the people of Japan and we wish them well in the trying period ahead.
We want to make it clear from the outset that this article was written before the Japanese crisis started. We continue to believe that stock market remains in a secular downtrend that began in early 2000. In the late 1990s we were convinced that when the financial mania reached its peak, we would enter a secular (long-term) deflationary decline in the stock market (see attachment). The main reason for this view was the outright insanity of the dot-com bubble along with highly excessive valuations, extreme debt levels and the potential vulnerability of the housing market.
In this "special report" we will attempt to explain our macro viewpoint. We will show why we believe that the U.S. stock market is following the same path as Japan did when they entered a secular deflationary bear market at the very beginning of 1990. There are a lot of similarities between the U.S. and Japan and there are also many differences. This is all explained in another "special report" titled, "Is America Following the same Path as Japan?" which we wrote this past December. Both countries have been obligated to issue tremendous amounts of government debt to offset the necessary deleveraging of debt in the private sector. Both countries also exhibited signs of irrational exuberance in their stock markets. While Japan's excess debt was in the non-financial corporate area, the U.S. excess debt resided in the household sector. The secular deflationary bear market the U.S. entered into 11 years ago may eventually be just as long and painful as Japan's. This is especially so since we had a second bout of "irrational exuberance" revolving around a housing bubble and a secondary stock market bubble from 2003 to 2007 after the Fed lowered the Fed Funds rate from 6.25% to 1% and kept it there for an extended period. In addition the total debt, household debt, government debt and unfunded liabilities are so outlandish relative to our GDP, that we are in a box that will be very difficult to climb out.
The Fed is trying to generate another stock market bubble now, with another round of low interest rates, quantitative easing (QE) and QE2. They have been successful so far in generating a market move of around 100% from the March 2009 low, but we would be shocked if the market rose to new highs. In fact, we may have already made the Fed inspired market peak at around 1350 for the S&P 500.
In addition, we believe the pundits that are constantly using $100 earnings for the S&P 500 and a 15 PE to magically come up with 1500 on the index are guilty of faulty reasoning. We will instead explain why current valuations are extremely high and why we expect the valuation metrics to decline to the levels seen at typical stock market bottoms.
Why We were Convinced that the U.S. would Enter a Secular Bear Market After the Mania Ended
We found that during the financial mania of the late 1990s we were writing the same thing, comment after comment. We kept trying to explain why this financial mania was only comparable to Japan in 1989 (excluding the Tulip Mania and Mississippi Company Mania since the total value of these manias was so small). We couldn't have been more convinced of the ending of this mania bringing on a severe secular bear market that would take years to remedy, just like Japan.
The definition of a secular (very long) bear market are markets that either crashed or markets that produced very little if any gain over many years. There have been four secular bear markets over the past 100 years in the U.S. (chart attached). Examples of these long lasting bear markets were from 1906 to 1921, 1929 to 1942, 1966 to 1982, and 2000 to present. We expect the current secular bear market to go on for many more years. Within all of these long term bear markets, were significant cyclical rises in the stock market that produced no gains over the life of the bear (chart attached).
Although the definition of secular bull and bear markets are not carved in stone, we believe that the NDR chart shown in the attachment is pretty close to where we would categorize them. It is clear from observing the chart that the period of time between these long term bear markets were separated by secular bull markets that have accounted for ALL of the stock market gains over the past 100 years. For example, the period of 1921 to 1929 produced gains in the DJIA from around 60 to 300 before the 1929 crash. The period of 1942 to 1966 produced gains from around 100 to 1000 just before going into a long period of stagnation from 1966 to 1982 without exceeding 1000 again. The period of time that produced the largest gains was when the market bottomed at 770 in 1982 and finally broke out from the 16 year resistance of 1000 on the DJIA, finally reaching 11,700 in 2000.
As stated earlier, we were warning our readers that when the financial mania ended we would enter the fourth secular bear market in 100 years starting in 2000. The main reasons we were so sure that whenever the mania ended the secular bear market would be similar to that of Japan were the staggering debt levels in both countries and the insanity of their stock market valuations.
Reasons this Secular Bear Market Will Not End Soon
The four main reasons the secular bear market will not end soon are the late 1990s financial mania, the overhang of housing inventories, the excess debt, and the continuing overvaluation of the stock market.
The first of the four main reasons we believe this secular bear market will have difficulty reversing into a secular bull market is the extent of the "irrational exuberance" in the period 1996-1999. Remember, during the mania there were two dot com companies without earnings that had a combined market capitalization that exceeded the total market capitalization of eight large blue chip companies (including International Paper, AT&T, Honeywell, etc). These two stocks (CMGI, and Internet Capital Group) each traded above $250 per share before declining to under $2 after the dot com crash. There are many other examples of the mania but suffice it to say that the P/E ratio of the NASDAQ, after trading at an average of 17 P/E over the prior 15 years, rose to 245 P/E before the crash. Other examples of the mania can be found on our home page by scrolling down to the "Money Show" in Atlantic City.
The second reason for our view that the secular bear market is not over is the continuing weakness of the housing market (see second attachment). When the Fed lowered interest rates from 6.25% to 1% and kept it there for an unusually long period it helped cause a major bubble in the housing market as well as a strong cyclical bull market within the secular bear trend. We still have a major overhang of housing inventory where if you include the shadow inventory (inventory held by the banks) the total exceeds 6.3 million homes, an all time record. We discussed this potential problem as early as mid 2003 with a "special report" titled, "Real Estate-The Catalyst of the next Deflationary Bear Market."
The third major problem that continues to plague the U.S. economy is the highly excessive debt. Total debt (public and private) as a percentage of GDP in this country presently exceeds the total debt relative to GDP during the Great Depression (chart attached). Keep in mind that this chart shows our total debt/GDP ratio now exceeding 355% vs. 265% in the 1930s. Therefore the current ratio now exceeds the ratio in the Great Depression debt/GDP even after the GDP collapsed in the depression!! But this is not the total story since the promises our government made (entitlements and unfunded pension plans of government workers) could be as high as double the $52.4 trillion of total debt or close to another $100 trillion!
It is this debt and deficits that the new Republicans and Tea Party representatives, who were elected last November, have promised their constituency to slash. The problem is that we can't have it both ways. We can't use austerity measures to cut the debt and deficits without adversely affecting current growth in GDP. We already have the problem of excess household debt that is in the process of being deleveraged and is a major risk to the economic recovery. But attempting to "do the right thing" now (cutting the debt and deficits in such a fragile recovery) could drive us into the dreaded "double-dip".
The fourth reason we believe that the secular bear market is not over is the valuation of the market. Earlier we discussed how so many pundits were expecting $100 in earnings and placing a "normal" P/E on these "operating" earnings in order to show an undervalued stock market. Please keep in mind that during the first six months of 2008 most analysts were predicting the same forward looking earnings ($100) on an "operating" basis for the full year of 2008. Well as it turned out the earnings didn't quite come in at $100, but instead came in at half of that!! Moreover, the reported (GAAP) earnings that were used for the 80 years prior to the mid 1980s, came in at a paltry $15. Remember, "operating" earnings exclude "write-offs" and were only used to inflate stock prices. Maybe we are beating a dead horse with this analysis but if you want to read more about why it makes NO sense to use "operating" earnings please scroll down on our home page to "Comstock in the News" to read some Barron's articles on our reasoning (Eg. What is the Real P/E). The bottom line is that we expect the same disappointment by the pundits this year. The profit margins are at record levels now (chart attached) and they are mean reverting, which is a major negative for future earnings since it is now at a peak.
However, even if the earnings do come in at $100 we don't believe that we will be able to exit the secular bear market without trading down to the levels typically seen at bear market bottoms. We will show you a chart which shows where the valuation metrics typically trade at major market bottoms. After the financial mania and two 50% decline within the same decade, you would have to conclude that this secular bear market will have to trade at the typical bear market levels before it ends.
To conclude, we expect the secular bear market to continue for years to come, and the main criteria to watch for in forming a bear market bottom is the valuation metrics. If the stock market retreats to prior bear market bottoms, we could be close to a bear market bottom and the start of a new secular BULL market. You can monitor these metrics on our home page through "Limbo, Limbo, How Low Can it Go"?