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Comstock Partners, Inc.
How Low Can It Go?
October 09, 2008
Fear & Capitulation Stage of Bear Market

We believe that the market has further to go on the downside.  The stock market would have to meet a few more requirements for us to at least move to a neutral stance before we hopefully can turn bullish.


The first requirement is for a "wash-out" event of public capitulation precipitated by major redemptions of equity mutual funds and massive selling of equities by the public, hedge funds, and the institutions that are forced to liquidate due to public redemptions. 


The second requirement would be for stocks to trade down to the levels that we would consider attractive values.  We have been updating the "Limbo, Limbo, How Low Can it Go?" article on the right side of our home page every few months, and it has recently been updated.  Ever since we authored "Limbo, Limbo" in early 2000 the stock market has never reached levels that we would consider attractive.  The article shows five different metrics to measure the valuation of the stock market-Price to Dividends, Price to Sales, Price to Cash Flow, Price to Book Value, and Price to Earnings. 


The third requirement for us to get more positive is for Housing Prices to decline to more normal levels of under 3 times median family income after rising to over 5 times median income in 2006.  This would require home prices that have already declined by 20% to decline by another 20%.  The deleveraging of the record debt will accompany the housing price decline.  We will only deal with the capitulation in this comment, but you should visit "Limbo, Limbo" to see how overvalued the market is except for the price to book metric. 


The last stage of panic selling is in the process of meeting our goal, but has not yet reached the level of massive capitulation that would be needed to counter the outrageous speculation that took place in the late 1990s and from 2003 to 2006 in both equities and home prices.  The equity mutual fund redemptions in 2002 did not come close to the liquidation we expected after the financial mania of the late 1990s and the latest redemptions in 2007 and 2008 have so far not reached the levels we would expect in order to be classified as enough capitulation to end the final stage of the bear market.


One of the best ways to measure the last stage of the bear market is to monitor the public's participation in the equity market through the net purchases and sales of equity mutual funds.  Thanks to the Investment Company Institute, such figures are readily available.  For example, net inflows into equity mutual funds during the first quarter of 2000 were far greater than in any other quarter in history.  As you know, this coincided with the peak of the financial mania.  Net inflows in the quarter amounted to $101 billion ($141 with foreign equities included), largely concentrated in the Nasdaq high tech and growth stocks that were the main targets of the blood bath that followed.  These purchases along with some additional buying throughout the year brought total equity mutual fund assets up to a record at the time of $4 trillion ($4.6 trillion with foreign equities) in August 2000.


History is replete with examples of massive herd-like public purchases at the peak of financial asset prices and emotional liquidations at the troughs.  A number of financial and economic studies have covered this topic from the tulip bulb craze in the 1600s to the crash of 1929.  Although culture, technology and financial instruments undergo great change over time, human nature remains the same and emotional highs and lows in financial markets are facts of life that never change.  A modern example is the early 1980s financing and marketing of oil and gas shelters from the drilling areas of Texas and the Gulf of Mexico to Wall Street where there seemed to be unlimited demand for anything to do with oil and gas.  This demand coincided with the peak in oil and gas prices in the early 1980s leading to heavy losses, bankruptcies, a crash in Texas home prices, and the necessity to bail out every sizeable independent bank in the state. 


Another quick example of public "irrational exuberance" was the lines of people around the blocks of downtown Manhattan seeking to buy gold and gold coins just as the price of gold was peaking in 1980 at over $870 an ounce.  The latest example, of course, was the recent purchasing of mortgages by Wall Street and packaging them for sale to all of their customers all over the world.  Time after time, it's apparent that the public and many institutions always buy heavily what it most recently missed, and subsequently liquidates with major losses.


Some may believe that the net liquidation of about $91 billion ($98 billion including foreign equity funds) of equity mutual funds from June to October 2002 represented enough fear and capitulation to qualify as the third stage of that bear market.  This liquidation, however, pales by comparison to the prior bear markets.  Total equity mutual funds (EMF) liquidation for the entire year of 2002 was only $25 billion ($26 billion with foreign), representing only a little more than 0.5% of the $4 trillion of total EMF assets.  To put this in perspective, there were 12 other years since 1970 where total outflows were much higher.  In fact, after the bear market of 1973-1974, every year between 1976 and 1979 recorded outflows between 10 and 12% of total EMF assets.  Furthermore, eight other years recorded net outflows ranging from 1.2% to 8% of assets.  This means that the net outflows in 2002 were only the 13th largest on an annual basis since 1970-and this followed the greatest financial bubble ever.


Some may argue that stocks and equity mutual funds have much broader ownership now than ever before.  And 401 Ks are responsible for a lot of the wider ownership.  To us that makes the problem even worse and when the public panics near the end or at the end of severe bear markets, the more public ownership, the more people that are able to panic.


The fact that the public has come back into equity mutual funds with a vengeance over the bull market years of 2003 to 2006 with just under $300 billion of net purchases ($717 bn with foreign EMFs) is of even more concern to us since it is likely to make the final stage of eventual capitulation that much worse.  Total assets of EMFs of $4.2 trillion are just over the peak reached in mid-2000 of $4.0 trillion.  If foreign equity funds are included the total is now $5.5 trillion (with net purchases in 2007 of $93 billion) vs. $4.5 trillion in 2000.


If this global bear market is as bad as we think, we should expect redemptions of at least 10% of the total EMFs before it ends.  This would make the total net liquidations of domestic equity mutual funds of around $400 billion and if you include foreign EMFs the total would be about $550 billion.  So far (as you can see in the attachment) we have liquidated just over $135 billion of domestic EMFs and just under $105 billion if you include foreign EMFs.  Until the third stage of the bear market is complete, and the fear and capitulation become even more obvious, the market remains extremely vulnerable.

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