At Comstock we continue to believe that the world is in an accelerating
deflationary environment. This is the
result of many interrelated factors we have written about in the past. The
most important of these is the exceedingly large levels of debt that exist in
the world today. In an effort to combat this deflation and
stimulate the real economy the Federal Reserve has done three quantitative
easings (QEs) and an “Operation Twist” (purchase of long term and sale of short
term government securities). These
actions grew the Fed’s balance sheet from $800B to over $4.5T. Also, as part of this program, it has
maintained a zero interest rate policy (ZIRP) for 84 months. This has not only punished traditional savers
but has forced many of those savers to take risk in financial markets with
money they cannot afford to lose. But the
real economy has not been stimulated in any meaningful sense. The main effect has been the inflation of
financial assets, real estate and certain art.
We strongly believe that ZIRP has made the financial markets much more
vulnerable than normal.
As is evident from trends in GDP and its revisions, the US economy
continues to grow at an anemic 2%-2.5% since the bursting of the Housing Bubble
in 2008. Globally, GDP has grown by 5.3%
($28T to $78T) over the past 10 years while Total Global Debt has grown by 9% ($40T
to $225T); with much of the slowest growth being more recent. Not only is this not sustainable but it is, in
fact, the main reason growth worldwide is so poor. As further evidence of the deflationary
situation the world is in, the Bloomberg Commodity Index, which calculates back
to 1991 and is broadly representative of
the entire commodity complex, is at its lowest level since 1999 and not far from
its lowest level in that entire 24 year time frame. Commodities across many complexes are
screaming deflation and warning of global recession.
Europe, Japan and China have now followed the United States
with QEs of their own. In response to
Japanese government policies the market has devalued the Japanese currency by
approximately 60% versus the dollar since 2012; and in spite of that, the
Japanese economy has just entered another recession! Growth numbers in China remain highly
suspect and the Chinese economy has been overbuilt though massive debt to
levels where productive capacity far exceeds aggregate demand.
Today, the ECB unveiled its latest attempt to stimulate the
economy. It expanded the bond buying
program to 360 billion euros, extended the length of QE by 6 months to March
2017, included local and regional debt in the mix of assets it would buy and
reduced the deposit rate by -10 bps to -.3%.
The latter also becomes the floor rate that it will pay in the
marketplace for credit instruments. Interest
rates are already negative out to 6 years in Germany and out to 4 years in
France and we expect this action over time to weaken rates further. The sum of this is worldwide deflation, plain
One of the main observations made in the bull case for
equities is that corporations continue to buy back large volumes of their
outstanding stock. In fact, for many
companies, that accounts for more EPS increases than does improved revenues or
margins. But, it should also be noted
that these purchases have been in record amounts financed with debt for the
past several years. Corporate debt
issuance surpassed $1T in the United States in the first 9 months of this year,
for only the second time ever. In fact,
debt is more, not less, expensive in a deflationary environment. Therefore we expect these large debt levels
to act as an albatross around corporate necks for years to come. It should also be noted that share
repurchases are taking place at valuation levels that we consider extremely inflated
by historical standards.
By and large technology and financial innovation has been a
good thing in many ways, but we think, relative to market liquidity it is a two
edged sword. Fully electronic trading
and penny spreads have in large part caused markets to become less liquid. The traditional NYSE Specialist and Nasdaq
Market Makers do not exist in the form they did in the past. Market making today is more “technology
arbitrage”, where the objective is trying to be proficient in squeezing out
fractions of pennies based on taking advantage of the quirks, rules and business
models that exist as part of market microstructure. We, therefore, believe that when most needed,
liquidity will be greatly diminished.
We’ve seen this before, going all the way back to the “crash of 87” and
most recently through the “flash crash” on August 24th of this year. Additionally, we believe that those ETF’s
that contain illiquid securities (e.g. Junk Bonds) will prove to be no more liquid
than the securities they contain, and will therefore not provide investors with
a safe haven.
In summary, we believe the market is very
vulnerable and extremely overvalued. We
are not looking for a mild correction here, but rather believe that a move far
lower is justified.