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Comstock Partners, Inc.
Prospering Bears-An Interview With Barron's
September 02, 2002
Stocks are still overvalued, say Comstock Partners, and real estate is shaky too

An Interview With Charlie Minter and Marty Weiner -- After delivering heroic gains in 1987, Comstock Partners and its two funds, Strategy and Capital Value, struggled throughout most of the 'Nineties to recapture the winning formula that worked so well for the firm in the late 'Eighties. It was a top-down strategy that emphasized historical-valuation analysis, and as practiced by Charlie, a protégé of Comstock co-founder and onetime Merrill Lynch strategist Stanley Salvigsen, and Marty, a former portfolio manager for Grumman Corp.'s pension plan, it proved inadequate against the momentum that gripped stocks much of the last decade. Once again, however, Comstock is having its day in the sun. And Mario Gabelli, who added the outfit to his empire in May 2000, couldn't have shown better timing. The Comstock Capital Value Fund is up more than 30% so far this year after gaining 22% in 2001 and 9% in 2000. The Comstock Strategy Fund is up 13.64% this year, following an advance of 10% in 2001 and 1% in 2000. And guess what? Charlie and Marty are still bearish. Here's why.

--Sandra Ward

Barron's: We've been in a bear market for two years and you gentlemen see no signs of letup. Elaborate on that, would you?

Minter: We don't like being bearish, and we would love to be able to change our opinion and turn bullish on the U.S. stock market. But when we look at the historical-valuation metrics, we find it very difficult to get enthusiastic about buying common stocks. When we superimpose other historical facts on top of the overvaluation -- unprecedented participation by the public and foreigners in the stock market, for instance -- we get downright bearish.

Q: Speak to the valuation. How overvalued is the Standard & Poor's 500 at this point? And what about Nasdaq? What's fair value?

Weiner: The S&P 500 is still selling at 34 times trailing reported earnings and 27 times consensus earnings estimates for 2002. Historically, the S&P has traded at about 15 times earnings on average, and at the bottom of a bear market it has almost always sold at 10 to 12 times earnings. The market is still overvalued at this point, and it's vulnerable with the economy so very fragile.

Minter, left, and Weiner: Post-bubble imbalances have yet to be corrected, they say, including low consumer savings, the trade deficit, excess capacity and high debt.

Q: What about Nasdaq?

Minter: The Nasdaq doesn't have a price-earnings ratio because the losses by companies in the index outweigh any profits. At the peak of the market, Nasdaq sold at a multiple of 245 times earnings.

Q: At what level does it become attractive to you. Here?

Minter: It still doesn't look attractive. We would have to look at each individual company on the Nasdaq, because it is really hard to say an index is overvalued or undervalued when there is no P/E to that index.

Q: But you are short the Nasdaq Trust shares, or the QQQs, so you must have done some valuation work on the index.

Weiner: We look at a lot of the individual stocks in the index and find that they are highly overvalued. We are also coming off a burst bubble, resembling the events of the Crash of 1929 and Japan in 1989, and where there were lots of distortions and imbalances, unlike conventional economic cycles, that have yet to be corrected.

Q: Where does this lead then? Are you forecasting a depression?

Weiner: Either the economic recovery is going to be very anemic or we are going to slide into renewed recession. These imbalances -- the low consumer savings rate, the trade deficit, excess capacity and high debt levels -- have to be corrected. As long as they exist, they are headwinds against economic growth. There's very little capital spending, and managements are saying there won't be any increase in capital spending, particularly in information technology, on the horizon anytime soon. Consumer spending is starting to fade after being the major driver of the economy. We expect the economy to really soften again at this point.

Q: What about government spending?

Weiner: Government spending could help a bit, but it also increases the deficit, which is not good for the economy.

Q: Given that capital spending shows no sign of a pickup, consumer spending is fading and there are some real risks to increased government spending, what does it all add up to?

Weiner: The economy is at risk. And the earnings estimates we are using currently to show the market is overvalued also are at risk.

Minter: In the past, markets have always peaked around 20 times earnings and hit a trough around 10 times earnings. This time, the market multiple got up to 32 times earnings at the peak. As earnings have collapsed, the P/E ratio on the S&P 500 is now about 34 times trailing 12-month earnings. We aren't big fans of using forward earnings, because we don't believe many people really know what the forward earnings will be. The P/E valuation is the major, major metric we use in staying away from the stock market. The Nasdaq is more overvalued than the S&P because it has an infinite P/E. Combine that with our concerns about the economy and the fact we are completely convinced the Fed won't be able to generate more spending by the consumer, and we are led to believe this is a deflationary bear market. It may turn out to be worse than a conventional recession. Owning cash is important in this environment. If you can tolerate the risk of owning Treasury bonds and notes, we would advise you to do that.

Table: Peaks and Troughs

Q: People talk all the time about good deflation and dangerous deflation. Why do you think this is a negative?

Minter: This won't be a good deflation because of the record amount of debt held by consumers and corporations.

Weiner: Debt is the key. When asset values come down, the economy comes down and the means of repaying debt decline.

Minter: The time to take on debt is during inflationary times. It enables people to pay their debt back with cheaper dollars. And then they can invest in real goods and be the beneficiary of the increased price of the real goods. At times of deflation, those real goods come down in value and cash becomes very attractive, as it allows you to buy those real goods at lower prices. The next worry is the devaluation stage, and that's where we are right now. The dollar corrected pretty substantially relative to the euro and the yen during the past few months before stabilizing recently. But in order to sell goods in this environment, it will be necessary to devalue the currency. That becomes a competitive process, and other countries will have to devalue theirs in order to sell their goods to us.

Q: A lot of people say we haven't yet seen the kind of fear and capitulation that typically mark the end of a bear market. One of your focuses is public participation in stocks. What do you think?

Weiner: The high multiple on the S&P is an indication that people are still relatively optimistic on the market. The Investors Intelligence survey shows investment advisers are still mainly bullish. Only about 31% of these advisers are bearish, compared with 60% or more in every other bottom made in the last 40 years or so.

Another measurement of the fear and capitulation is the percent of cash held in equity mutual funds. At previous market bottoms, this amounted to between 10% and 13% cash as a percentage of assets. Right now, it's only 4.6%, which is at the real low end of the range. Anecdotally, a lot of people have held onto their stocks and are praying for a recovery. We are in the stage of the market where fear and capitulation tend to take over, but it hasn't taken place yet. The amount of equity mutual funds peaked in the first quarter of 2000 at a grand total of $4.5 trillion with about $4 trillion accumulated in the decade of the 'Nineties and mostly in the last few years of the 'Nineties. This represented about 30% of total stock-market capitalization, and it is our strong opinion that much of this will be unwound before the current bear market ends.

Q: How much has been unwound to date?

Minter: It is down to $3 trillion, or 37.5% of total stock-market capitalization. In 1972, the numbers were about $56 billion in equity mutual funds at the peak of the market. Total market capitalization then was about a $1 trillion, so the amount in equity funds represented about 5.5% of the total market cap compared with over 30% now. The number of equity funds peaked in 1972 at 365. There were 314 at the end of 1974. The bear market ended in December of 1974, but the number of funds continued to decline until by the end of the decade in 1980 they totaled 288. At the 2000 peak, the number of equity funds totaled 4,000, and now there are 4,800. Until we see that number starting to go the other way, this bear market won't end.

Q: Do you take into account that the decade of the 'Nineties was also the decade of the 401(k) plan?

Weiner: People with 401(k)s aren't confined to equities, they have a choice where they are going to put their money. It is also easier to change allocations than it ever was before.

Q: But these investors have been told time and time again not to time the market.

Weiner: It is always easy to say buy and hold, but people change their minds when you get a couple of down years. When the stock market peaked in 1929, the market didn't reach that point again until 25 years later, in 1954. When 1,000 was approached on the Dow in 1966, it was 16 years before the market surpassed that level in 1982. You can go through very long periods with the market not going anywhere. It is true that over very long periods stocks have returned on average about 10% a year. It is also very important to remember that of that 10% return, 4% came from dividends. The dividend yield today is about 1.7%.

Minter: The next leg down in the stock market will probably bring out the fear and capitulation, but we think that's a major negative more than a positive. This time, when individuals decide to pull out of stocks, there are such low levels of cash in mutual funds that in order to meet redemptions, fund managers are going to have to sell common stocks.

Q: Have we started to see foreign owners liquidate?

Minter: Foreigners haven't started liquidating. But we own the euro in both our portfolios, betting that as the dollar starts going down with the stock market, foreigners will wind up pulling out their investments in U.S. dollar-based securities. Foreign participation in U.S. equities is about $4 trillion.

Q: Hasn't buoyancy in the real-estate market cushioned the blow investors have had in the stock market?

Minter: No question about it.

Weiner: There has been some switching to real estate from the stock market, and real estate looks more and more like a bubble.

Minter: There is a P/E ratio in real estate as there is with common stocks. In real estate, it's a matter of how much rental income can be achieved from the purchase of a home or the purchase of an office building. If rental income isn't going up relative to the prices paid, then you have to be concerned. We are very much concerned now. Prices paid have gone up over the past seven years much faster than rental income. If rental incomes don't rise, there's a good possibility there'll be a decline in housing prices.

Q: Isn't leverage an issue for homeowners?

Minter: Home equity is down to 55% of the value of the home, which is a low point in the cycle. Despite the sharp rise in house prices, equity in homes has actually dropped. Another disturbing fact is that the housing vacancy rate reached 9.1% in the first quarter of 2002, the highest rate on record since the Census Bureau first began collecting data in 1960.

Q: Are you positioned to take advantage of any cyclical bull rallies in the bear market?

Minter: When we think the capitulation stage has hit hard and we see liquidation by foreigners and the investing public, and we think the market's been driven down enough, we will play any cyclical bull market. There were rallies that took place in the pre-1974 bear-market period, and there were also six bull rallies during the bear market in Japan in which the market rose more than 25%. But so far, we haven't tried to play any rallies that have occurred in the past 2½ years. Instead, we have advised people to sell more of their stocks in these rallies, and, if they can tolerate the risk, we advise them to sell stocks short or buy our fund.

Q: You have suggested the capitulation you are looking for could occur in the third quarter when earnings come in more poorly than expected.

Weiner: The market's been in a quiet period. Most of the companies on a calendar second-quarter schedule have reported. We saw some of the bad news on accounting diminish as of Aug. 14 when managements had to certify their statements. This lull is only temporary, however. We're soon going to get into the pre-announcement season, and every indication we've had so far from various corporate managements is that earnings are going to be revised downward. We're seeing it in technology, we're seeing it from retailers, and after Labor Day we are going to see a lot more bad news.

Q: Which sectors are you shorting?

Weiner: We're shorting technology very heavily and financial stocks such as brokers and asset-management companies.

Q: What areas within technology are you shorting?

Weiner: One area we are particularly negative on is semiconductor equipment. The overall semiconductor sector is very weak. Every one of its end markets -- PCs, servers, cellphones and telecom -- is very weak. Chip companies are cutting their capital spending. This really hurts the semiconductor-equipment makers, which are on the tail end of the negative demand. KLA-Tencor trades at 33 times earnings. It earned $1.10 a share in its fiscal 2002 ended June and is expected to earn $1.18 a share in fiscal 2003. Here's a company that earned about $1.17 in 1996, and the bullish estimates for 2003 are $1.18 a share. Is this really a growth company? Applied Materials and Credence Systems are similarly overpriced.

Minter: It's important to note that we never short stocks until they begin to break down. If they then go up again and they make a new high, we use a stop-loss on every single one of them and at that point we cut our losses. We don't stay with things that make new highs.

Q: What about biotechs?

Weiner: We're short biotechs. We're short the Biotech HOLDRs Trust that trades on the American Stock Exchange as well as a couple of individual biotech stocks. We think biotechs are highly overvalued, and while we're certain some of them will come up with real blockbusters in the future, we think the majority of drugs they are developing will prove disappointing and the stocks will be vulnerable.

Minter: Financials are where we are concentrating. Any company that's involved with money management we look at as a prospective short sale.

Q: What about banks?

Minter: We haven't been short too many banks, but we are looking at that area right now. We've come close a few times to shorting specific banks. We're watching them very carefully now.

Q: How are your portfolios structured?

Minter: The Capital Value Fund is approximately 130% net short. About 80% of the fund is in U.S. Treasury notes and 7% is in 10-year U.S. Treasury bonds. We have a 4% position in the euro. We have 10% in put options on the S&P 500, and are about 20% short S&P futures. And we are 34% short common stocks. We have no longs. This adds up to more than 100% because of the common-stock shorts and futures. In the Strategy Fund, we have 45% Treasury bills, 14% in 10-year Treasury bonds. We have 20% in Treasury bonds with 30-year maturities. We have 13% in puts on the S&P index and an 8% position in the euro. This adds up to a 95% net short position when you consider the notional value of the puts.

Q: When was the last time you gentlemen were bullish?

Minter: We weren't bullish throughout most of the 'Nineties, and we lost money in the late 'Nineties. We were very bullish on bonds from 1987 until about 1993, and then turned bearish on bonds and stocks in the mid-'Nineties and aggressively shorted during the bubble.

Q: What made you so cautious so early in 'Nineties? Had 1987 so altered the way you viewed the market?

Minter: My then partners Mike Aronstein and Stan Salvigsen and I wrote a report in the early 'Eighties called the Big Enchilada. The report argued that the decade of the 'Eighties would be a great time to own stocks. At the peak in 1987, we sold out of common stocks. The fund was up about 48% and we purchased puts on the market on Aug. 25 of 1987 for the first time. We sold stocks short and we ended 1987 up 35%. Our timing hasn't been nearly as good since. We thought 1987 was the start of what could be at a minimum a cyclical bear market and possibly a secular bear market, and we really had trouble stepping back in. Then stocks got more and more overvalued through the latter part of the 'Nineties.

Q: Thank you both.

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