Comstock Partners, Inc.December 10, 1999
FEET DON'T FAIL ME NOW
Dated, but not out of date
The list of negative factors affecting the stock market has now become so numerous that it is highly likely that a severe bear market has already started. We begin with the fact that, as measured by earnings and dividends, this is by far the most overvalued market of the past century. In addition, breadth is crumbling, interest rates are rising, inflation is stirring and sentiment remains overly complacent. The Standard and Poor’s (S&P 500) peaked in July and has essentially gone nowhere since March. We believe this negative mix is too great a burden for the market to bear and that a major decline is imminent.
Comstock has been bearish for a longer time than we care to remember. The main reasons for our early bearishness were overvaluation, extreme positive sentiment and excessive speculation. Based on historical evidence this would have been enough to stop the market in its tracks and cause a significant decline. What we underestimated, however, was investor determination to participate in the market no matter what the valuation. For the initial part of the great bull move there was good reason for the market rise, but for the past few years stocks have risen on their own momentum and fundamentals such as price-to-earnings ratios and dividend yields have been virtually ignored.
We still believe that valuation, sentiment and speculation are important signs that the stock market is unsustainably high, although in this cycle at least they have proven to be poor indicators in timing the peak. More recently, however, two other indicators have turned decidedly negative; the direction of interest rates and overall monetary policy, and the internal condition of the market itself. In this connection we note that interest rates have been rising for 13 months since October 1998, and that monetary policy turned to a tightening mode in June 1999. In addition, since April 1998 more stocks have been declining than advancing (negative breadth). Declining breadth indicates that money flows into the market have declined so much that only a small minority of stocks are continuing to climb. When combined with rising interest rates, signs of inflation, high-valuation, complacent sentiment and excessive speculation, it is highly likely an important bear market has begun.
This is by far the most overvalued market in this century. Over a long period of time, P/E ratios have ranged from a high of 21 to a low of 7 with an over-all average of 15. In contrast, the S&P 500 is currently selling at 31 times earnings per share, 48% above the highest valuation previously recorded and 107% above the long-term average. In other words, from its August peak the S&P 500 would have to decline by 32% just to reach its previous valuation high and by 52% to reach its historical average. These are extremely conservative projections since in most bear markets the P/E multiple has undercut its average on the downside.
The same extreme overvaluation exists if we measure the market by dividend yield. Over a long period yields have ranged from 7.5% to 2.6% with a long-term average of 3.7%. The market would have to decline by 53% just to revert back to the previously historically low yield and by 67% to return to a normal yield.
History (Table 1) shows that the market never remains permanently overvalued or undervalued but periodically swings from one extreme to the other. The swing from overvalued to undervalued is the essence of a bear market and the table below indicates that this is a periodic occurrence in the U.S. stock market as it has been in all markets everywhere since ancient times. Human beings have made great progress in many areas but the alternation of emotions between greed and fear remain. Since the current market is starting from an extraordinarily high valuation, the decline this time could be particularly steep even if it only swings from high value to fair value.
This extreme valuation, however, has implications that go far beyond a mere cyclical bear market but has long-term consequences as well. There are many conservative, well-intentioned investment advisors who are warning investors that bear markets are possible, but that if you just ignore the fluctuations the market always comes back. This assertion is usually backed up with a long-term glossy chart in pretty colors showing that the stock market, in the long run, provides an annual average return of 10% to 11%, substantially beating both bonds and money market instruments over long periods. This is potentially dangerous advice. While its is true that the market has provided an average annual return of 10% to 11% over a very long period, it is a result of averaging sometimes lengthy periods when the average annual return was substantially above average with other long periods when the return was far below average. In other words, you had to be willing to hold stocks through the dire days of the 1930’s, when no one would touch them with a ten-foot pole, in order to achieve the long-term return.
We also note that historical total return includes dividend yields which averaged slightly under 4% annually and that the yield is only 1.2% now. Therefore, of the total return over time, only 6% to 7% per annum was attributable to stock market appreciation. Appropriately, this is about equivalent to the long-term earnings growth for the S&P 500, which averages about 6% annually. This is logical since for the entire nation long-term growth is limited to the sum of population growth, hours worked and productivity. Over a long period a stock market’s average gain tends to equal its increase in earnings. Starting from the current high P/E multiple of 31 times, this has distinctly negative long-term implications. Our current estimate for reported S&P 500 earnings for the four quarters ending in September 1999 is $43.70. If earnings continue to increase at their well-established historical growth rate of 6% annually, earnings ten years from now would be $84, an increase of 79%. If the market at that time valued these earnings at the historical average of 15 times, the S&P 500 index at that point would be 1260 which is 11% under the August 1999 high of 1418.
Does the possibility of a lower S&P 500 index ten years from now seem crazy? Well, listen to this. In the last century there have been 37 years in which the Dow Jones Industrials sold below a level reached 15 years earlier. For example, the Dow was lower in 1982 then in 1966, lower in 1974 then in 1959 and lower in 1949 than in 1926. In all these instances the market started from a period of high valuation and ended at a period of low valuation. Given that the market is far more highly valued than at any previous time, the probability that the market could be lower ten years from now is actually quite good. Therefore, long-term investors should be extremely cautious when they are purchasing equities at far above the normal valuation range. The risk is not merely a cyclical bear market which declines 20 to 40% and bounces right back, but a long period of secular stagnation and decline. Yes, the market always comes back, but not before the vast majority have sold out and sworn off stocks for life. The long-term gains come not from investing in stocks when their values are excessive and everyone wants them, but by being invested in the dark times when stocks are disdained as too risky for prudent people.
Coinciding with the cyclical movement in the market between over and undervaluation is the psychological swing between optimism and pessimism, greed and fear, and euphoria and depression. The bottom of a bear market is the best time to buy stocks, yet it is precisely at this point that the vast majority are overcome by fear and the media issues nightmarish scenarios of the future. Financial advisors now like to advise investors to be long-term holders or else they will miss the initial thrust off the bear market bottom and fail to achieve the long-term average return. They acknowledge that investors must be in the market at the lows, but they usually provide this advice in an aging bull market. When the bottom actually arrives, the majority are usually too gloomy to invest and long-term investing in equities falls out of favor. An excellent example is the 1979 "Death of Equities" Business Week cover story painting a dire picture of the future for stocks. Business Week’s arguments were not unique; they were merely reflecting the consensus of the times.
Market peaks, on the other hand, are the mirror image of bottoms. At tops euphoria reigns, all news is bullish, investment clubs flourish and mutual fund inflows are strong. At the same time, those who warn against the excess in the market are treated like Cassandra who, according to Greek legend, was fated by the gods never to be believed although she always told the truth. The market has for some time now exhibited euphoria, and it has lasted far longer than we expected. Valuation has been virtually discarded as a serious market factor while untold numbers of people have left their jobs to become full-time daytraders. IPOs continue to soar to unimagined heights on their first day of trading. Highly touted books become best sellers by maintaining that the Dow is presently worth 36,000 or 100,000 and "experts" herald the arrival of a new era.
The euphoria is accompanied by a huge increase in the number of people with a stake in the market. The number of shareholders jumped from 30 million in 1980 to 78 million in 1999 ( 48% of U.S. households). Paralleling this is the enormous rise the number of investment clubs. The National Association of Investment Clubs report a current total of 36,000, a ten-fold increase over the 3600 in 1980 when stocks were far cheaper, but highly unpopular. We note that this was not the first time the number of investment clubs climbed rapidly. The number of clubs jumped from only 2000 in 1956 to 14,000 in 1970, only to fall back to 3600 in 1980. Investors love to tell anyone who will listen that they are long-term holders, but the facts say otherwise. The vast majority buy near the peaks and sell near the bottoms.
"… Speculative manias typically commence with a displacement which excites speculative interest. The displacement may come either from an entirely new object of investment or from an increased profitability of established investments. It is followed by positive feedback as rising share prices induce inexperienced investors to enter the stock market, and results in euphoria – a sign that investors’ rationality is weakened. During the course of the mania, speculation becomes more diffuse and spreads to different classes of assets. New companies are floated to take advantage of the euphoria, investors leverage their gains using either financial derivatives or stock loans, credit becomes over extended, scandal and fraud proliferate, and the economy enters a period of financial distress which is the prelude to the onset of a crisis… although no two speculative manias are identical they develop along similar lines…. It is often said that speculation never changes because human nature remains the same… the early stock markets were moved by hopes and fears as much as their later counterparts. These emotions are unleashed during moments of speculative euphoria. They follow the path of least resistance, molding each mania, regardless of its historical context into common form. This explains why all great speculative events seem to repeat themselves…."
We believe the current market exhibits all the hallmarks of the past major mass manias; the abandonment of prudent valuation measures, the spread of irrationality and the widespread belief that the stock market is a one-way street to immense wealth.
Although markets characterized by extreme overvaluation and irrational speculation often fall under their own weight, sometimes other negative factors are required in order to tip the scales downward. In the current instance, the overvaluation and euphoria have been joined by bad breadth since April 1998, by rising interest rates since October 1998 and by Federal Reserve Board monetary restraint since June 1999. Breadth indicators measure the extent to which most stocks follow the major trend as defined by the Dow Jones Industrial Average (Dow) or the S&P 500. As most commonly used, breadth is the cumulative daily difference between the number of stocks advancing and the number declining. As such, it measures the trend of the average stock on an unweighted basis in contrast to the major averages which are heavily weighted by the largest stocks. Normally, breadth rises and falls with the major averages. However, toward the end of an important bullish move breadth and the trend begin to diverge with breadth turning down while the major averages continue to make new highs. This is a signal to investors that the internal structure of the market is weakening and that a change in the trend of the major averages is about to take place.
* To date the peak in the Dow was 11,365 in August 1999
Historically (Table 2), most of the important cyclical tops were preceded by breadth divergences. The longest-lasting divergences took place prior to the two most important downturns of the century, 1929 to 1932 and 1972 to 1974. The breadth and the Dow made simultaneous peaks in May 1928. Thereafter, breadth went into a downtrend as the Dow continued to make a succession of new highs until its final top in September of 1929, 16 months later. The Dow did not surpass this peak for another 25 years. Similarly, breadth made new highs along with the Dow in April 1971. Subsequently, breadth declined for 21 months while the Dow continued to make new highs until January 1973. The Dow then declined 45% and did not surpass its 1973 top until late 1982 almost ten years later.
In the current cycle breadth topped out in April 1998, 19 months ago. Some observers claim that since 19 months have passed without the major averages breaking down, breadth is no longer relevant. To the contrary, however, history indicates that the worst market declines, are preceded by the longest divergences between breadth and the averages. The length of the current divergence has now surpassed that of 1928-29 and is only two months short of the one from 1971-73.
The other important negative change in the market outlook is rising interest rates and the policy of monetary restraint by the Fed. Short and long-term interest rates have been in a rising trend since October 1998 while the Fed’s first move toward monetary restraint was a one-quarter point increase of the Fed Funds rate in late June. Both bond investors and the Fed became concerned about the potential of rising inflation as a result of a strong U.S. economy propelled by consumer spending, a recovering world economy, a rise in commodity prices and a potential U.S. shortage of labor with consequent pressure on wages. (We explain later why this inflation is likely to reverse to deflation) We believe a rising stock market further spurs consumer spending and adds to wage pressures and that only a stable or declining market can accomplish the soft landing that Greenspan and the Fed desire. This is Greenspan’s dilemma. How can he slow down the economy without puncturing the bubble?
To place current Fed policy in context let’s go back a bit in time. In the spring of 1998, the 30-year Treasury Bond yielded about 6% and the Fed was becoming concerned about potential inflationary pressures arising from a strong U.S. economy. This became a moot point, however, once the Asian economies began to unravel. This further weakened the already fragile Japanese economy and started to spread to South America as well. The potential prior inflation threat suddenly turned into a real deflationary threat, and the U.S. bond market became a safe haven for global funds with Treasury Bond yields eventually falling to 4.7% in October 1998. The worldwide financial situation seemed particularly threatening when the Fed had to help rescue Long Term Capital Management and instituted a series of Fed rate cuts totaling three-quarters of a point. This was accompanied and followed by some 150 rate cuts by central banks worldwide over the next few months as the globe became awash with liquidity. This stabilized developing world currencies and provided the spark for the beginning of a global economic recovery.
The U.S. economy, already strong, was further driven by the increased liquidity provided by the Fed, the flow of funds from overseas and the rapid recovery of the stock market. Sensing that the acute financial crisis had bottomed, U.S. bond yields bottomed at 4.7% in October 1998 and began to climb. Bond yields continued to increase in the first half of 1999 as the bond vigilantes became concerned about the surge in U.S. consumer spending, the rise in commodity prices and the low unemployment rate and dwindling labor supply which threatened to put upward pressure on wages. In May 1999 the Fed, too, became concerned about potential inflation and Greenspan, operating under the new transparency policy, began sending signals that an interest rate increase was likely. As a result the market reached an interim peak in May and began to correct on the news.
This is where the Fed’s problems started. Although actual inflation was not yet a reality, Greenspan realized he had to make a pre-emptive strike against inflation by slowing down the too-rapid growth in consumer spending by means of an increase in short-term interest rates. But under the policy of transparency, he signaled the rate increase in advance and came through with a widely expected minimal one-quarter point hike in late June. In addition, he went from a tightening bias to a neutral one. This well-telegraphed and minimal action ignited a much-relieved stock market, which as Greenspan himself acknowledged many times, is a major driver of consumer spending. Thus, the small rate increase and return to a neutral bias actually worked against the Fed’s desired policy of containing inflation.
Recognizing the unintended explosive effect he had on the market, Greenspan a few weeks later took a much more hawkish posture at the Humphrey-Hawkins hearings, attempting to counteract the unintended boost he gave to the stock market in June. Without saying so directly, this was a de facto return to a tightening bias. The stock market received the message and backed off again. Since that time Greenspan and other Federal Reserve board members have given a series of seemingly contradictory speeches, sometimes issuing dire warnings about inflation and at other times saying it wasn’t really a problem. In August, in a key speech at Jackson Hole, Greenspan made clear his belief that the Fed had to keep an eye on asset values as a driver of consumer spending. In October, he warned the banking industry to maintain adequate safeguards in case of declining financial markets.
In our view the market is approaching a no-win situation. If it moves higher it brings with it higher consumer spending, a strong economy and higher inflation and interest rates. If this happens the market will decline significantly. On the other hand, more pre-emptive tightening by the Fed could burst the speculative market bubble, resulting in a worldwide recession and deflation. It is therefore apparent that, despite the current robust economy and low inflation, Greenspan is actually walking a high wire. He is afraid to exacerbate the bubble, but is equally afraid to puncture it as Japan did in 1989, and there is little maneuvering room in between.
To this point we have said little about our previously-stated deflation theme since current government policy is based on fighting inflation. It is therefore important to repeat our view that significant inflation is unlikely to take hold because the Fed and the bond market vigilantes simply will not allow it. At the merest perception of inflation long bonds have risen 160 basis points and the Fed has engineered two successive increases in interest rates. The Fed’s objective is a soft landing for the economy with no inflation. Since the stock market gains have spurred consumer spending (i.e., the wealth effect) to a point unprecedented in history, a rising market would make the economy stronger and defeat the Fed’s objective. The market is no longer responding to the economy; the economy is reacting to the market. Therefore, even if we underestimate the forces of inflation the Fed will keep raising rates until it achieves its goals. Once that happens the stock market bubble will burst and a bear market accompanied by deflation will ensue.
Despite a robust economy and low current inflation, the stock market is facing a number of negative factors which are reminiscent of conditions which typified past important tops in the market. These are: the highest valuations of the century, rampant speculation in "new era" equities, sharply declining breadth and restrictive monetary policy. In order to foster an economic soft-landing the Fed must dampen consumer spending which means it must keep a lid on the stock market as well. The ideal solution would be a trading range market which neither rises nor declines too sharply. Unfortunately, however, it is the nature of a bubble to keep expanding until it collapses. We know of no past market bubble which did not ultimately end badly.