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Comstock Partners, Inc.
Stock Market Volatility since 1994
September 06, 2011
The Swings to the Upside were Speculative, Debt Ridden, Bear Market Traps

The attached chart shows the volatility of the U.S. stock market from 1994 to present (see attachment -credit to MarketSmith).  In this "Special Report" we will describe the extreme moves along with a narrative to explain what drove the volatility.  The chart shows the up move from 1994 to 2000 (440 to 1550), then the downswing from 2000 to the end of 2002 (1550 to 770).  Next, the chart shows the up move from 2002 to October 2007 (770 to 1570).  The S&P 500 declined to the March 2009 low at 670.  This was followed by the upswing to April of 2011 (1340) as the market doubled within 2 years (this has only happened twice before in history).  Presently, it looks to us like the next down move is in full swing as the S&P broke down through the support of 1250 and fell as low as 1100, which we believe will be broken sometime this year. 

The stock market (based on the S&P 500) has been in a series of volatile moves ever since the 1987 crash.  However, the volatility really picked up from 1994 to 2000 if you take into account the NASDAQ financial mania where valuations were not based on earnings or even revenues, but rather on new esoteric metrics that had no proven basis for determining future revenue streams (e.g. the potential eyeballs that could view the mostly high-tech products and computer screens).  That was a period of time that the NASDAQ fundamentals were an absolute joke.  That index started trading in 1971 and from 1991 to 1997 traded in a Price Earnings (P/E) range of 30 to 50.  But, in 1997 it broke out and led the greatest bubble in all of history by reaching a P/E of 245 on 1/31/2000.  The P/E of the S&P 500 also rose to 32 surpassing all other peak P/Es by about 50% (see Limbo, Limbo, How Low Can it Go? -"market peaks and troughs"-- on our home page).  The value of the NASDAQ at the peak was $6.7 trillion, but once the financial bubble broke it lost over $4 trillion of the $6.7 trillion in less than a year.  Examples of this speculative bubble were Internet Capital Group and CMGI, both internet incubator companies without earnings.  When Internet Capital was trading at 212 and CMGI was trading at 263 a share they were both worth about $60 billion apiece.  They were virtually worthless a couple of years later.   
The stock market (based on the S&P 500) seems to be in a rhythm since entering what we have consistently described as a "secular bear market" that started in 2000.  The peak of 1550 in 2000 was followed by a decline to about 800 in 2002.  We understood the severe market decline but could not get bullish with the  P/E ratio still above 25 based on the S&P 500 trailing 12 months earnings.  We expected the P/E ratio to fall to, at the highest, about 10 times trailing 12 month earnings.  Also, the debt that was incurred by both the public and private sectors during the financial bubble was not close to being liquidated.  This usually happens during the disinflations and deflations that typically follow a debt driven upswing in the market and the economy.

By the middle of 2003, the Fed lowered interest rates from 6% to 1% and started another stock market bubble accompanied by a housing bubble.  This drove the market back to about the same area of the peak in 2000 at around 1570.  We were convinced that the U.S. institutions and individuals would not be fooled a second time around so soon after experiencing the financial mania of the late 1990s.  We were convinced that the Fed would not risk another bubble trying to avoid the natural deleveraging and asset deflation that typically follows a contraction in the economy.  They should have just let the free markets work and get out of the way as the price of stocks and housing fall to the levels that would have created true market demand. We believe this country would have been so much better off if they did.  The debt that was built up during the late 1990s, and from 2003 to 2007, would have been, paid off, defaulted on, or liquidated.  This process would have been very painful, but not nearly as painful as what we have experienced already and what we face in the future.   The myriad of problems resulting from starting a new round of debt accumulation before the prior round of debt accumulation was eradicated to some degree will cause us to go through much more pain before things get better.

This debt accumulation was so onerous that it finally developed into the "Financial Crisis" in 2007 and 2008.  Both the Administration and Fed did everything in its power to alleviate the pain.  However, all the Stimulus in the world, zero interest rates and all the QE's the Fed can dream up could not, and will not, overcome the risks and problems caused by the enormous public and private debt that has been accumulating for decades.  The government and American consumers spent well beyond their means for decades, but the worst overspending was in the last 12 years.  Now, after the election in 2010, the Republicans and Tea Partiers have so much influence that trying to stimulate even more will be virtually impossible. They will try to pursue the policies that should have been established in the 1980s and 1990s, but to "do the right thing" now will turn this country into another Euro Zone that also has no good solution.   

When the two bubbles (stocks and housing) burst, the market then traced back below the previous low of 800 in 2002 to 670 in March of 2009.  At 670 the market was so oversold that it had to bounce by at least 25% or so, but who would have thought (since the debt situation was not, and is not, any closer to a resolution) that it would climb all the way up to about 1370-- or just about double the 670 low two years earlier.  This has only occurred twice in history in 1934 and 1937 and both were followed by very weak stock markets over the next 6 months to a year (see attachment-credit to The Chart Store).  
The rhythm in the markets are staying in place as the market started a decline since the end of July and broke through the support of 1250 to virtually crash to the 1100 recent low.  We don't expect the S&P to rise above the 1250 resistance (now the support has turned into resistance).  However, if the investors in the country could drive the market all the way back to 1570 in 2007, with all the debt problems facing this country and then to 1370 after a significant correction, we guess it is always possible to again break through the 1250 resistance and test the 1370 resistance.  However, this is where we draw the line, and would be shocked if it broke through that resistance.  And we are even more convinced after reading the latest Barron's and seeing many of the top strategists calling for 1400 or higher by the end of this year.

Consumer Debt is Still the Main Problem, and we expect it to Decline as the Consumer Deleverages

The main fundamental reason that we question the resumption of the bull market is because of the tremendous household debt mostly taken on during the upswing from 2003 to 2007 when we had the double bubble of stocks and housing.  And this was before balance sheets were repaired from the debt mania build up during the financial mania of the late 1990s.  To put some numbers on this debt, if housing prices would have just appreciated with the inflation rate from 2003 to 2007, the total debt from household mortgages would have been about $5.5 trillion.  However, since the Administration, Congress, Wall Street-- banks, and the rating agencies made sure that anyone that wanted to have a home, whether they could afford it or not, got the "American Dream," the total household mortgage debt is presently about $10 trillion.  This extra $4.5 trillion of household mortgage debt is a terrible burden on the economy since consumers make up over 70% of our economy.  This is why consumer spending has been so tepid over the past few years as can be seen in the chart ( credit to NDR-Ned Davis Research two charts) on Personal Consumption Expenditures (PCE) during recoveries.  U.S. consumers spent well beyond their means for decades and now that they are so overleveraged their PCE will stay constrained for years.  The consumer spending didn't seem too onerous over the past few years until the Commerce Department lowered their earlier estimates significantly (see attachments).  Also, consumer confidence by any measure you chose is signaling another recession (see attachment-credit to NDR), and any cuts in federal or state government spending could only exacerbate that. 

We believe that the market rhythm we've described is forecasting an economy that is heading for a "double dip" recession and a stock market test of the March 2009 S&P 500 low of 670.  Any attempted rallies probably will not exceed the resistance at 1250 and should be sold in our opinion. 

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