Comstock Partners, Inc.March 22, 2012
Secular Bear Market?
Is Our Long Term View of a U.S.Secular Bear Market Still Valid?
We received a phone call over the weekend from a close friend and someone who reads our comments religiously. He had a question for us. He wanted to know if we were still in the secular bear market camp or have we thrown in the towel since the economic news has gotten much better and virtually every index is either at or close to new 52 week highs or are fairly close to all time highs. He explained that it looked to him that the European risk has moderated, the China "collapse" has evaporated, the jobs and housing problems of the U.S. have now clearly turned. We responded that we are still in the secular bear market camp and, in fact, are surer than ever that we are close to a significant peak in the market. He responded, "Please, explain yourselves." This is the logic we used.
First of all, we explained that this market (using the S&P 500 index-but DJIA and NASDAQ could also be used) has been in a secular bear market starting in 2000. You have to agree that the market sold at extremely high levels during the dot.com bubble before bursting in 2000 (the NASDAQ was much worse). Starting in 1998, when the market traded at extreme levels, the S&P 500 traded at 920 (with a P/E of 20 -the area of past peaks) before peaking at 1550, with a P/E multiple of 32 times earnings in March of 2000 (NASDAQ traded at 245 times earnings). Of course, you could go all the way back to 1994 when the S&P sold at 440 but was not at extremely high valuation levels. So, we are talking about a market that was overvalued in 1998 and has never since then traded at levels that could be considered cheap or even inexpensive after trading at extremely high valuation levels at the peak in 2000. So essentially, the stock market has not been considered inexpensive for the past 14 years and we surely expect the stock market to trade at typical bear market trough valuations (7 to 10 P/E) after two major bull market scams (dot.com & housing).
Now let's go to the extremes in the market for the past 14 years. After the bubble broke in 2000, the S&P 500 dropped to about 770 in 2002 and that is when the Fed (led by Alan Greenspan at the time) lowered interest rates to 1% in June of 2003 and kept them there for a year (they were also kept below 2% for three years). Fed funds were 6.5% in 2000! This started the housing bubble from 2002 to 2007 (along with the banks, mortgage companies, rating agencies, and investment bankers packaging mortgages and selling them to their clients) accompanied by another bubble in the stock market. And just imagine going into another stock market bubble less than 3 years from the most outrageous bubble of all time.
Rhythm of the Stock Market moves over the Past 14 Years (Doubling and then getting cut in Half)
This double bubble of housing and stocks drove the market back to the old highs of the year 2000 (1550), plus another 20 points to 1570 in October of 2007. So, we are talking about a stock market (represented by the most popular index) going from 440 at the end of 1994 to the bubble high of 1550 in March of 2000, and when the market finally broke got cut in half to 770 (with a still high valuation P/E of 26) in late 2002, before doubling again to 1570 in October of 2007. Then the market dropped again, this time by a little more than half (2.3) to 670 in March of 2009, and by breaking down below the 2002 low of 770 significantly weakened the market technically. At this March low, we were convinced that the market was so oversold, it had to rally. We, however, did not think that the market would double again since we couldn't believe the market participants would fall for another major "bear market trap" after experiencing the dot.com bubble of the late 1990s and the double bubble of 2002 to 2007.
We expected the housing market to decline to normal levels in the 2000 market break before the second bubble starting in 2002 and then again in 2009 after an oversold rally in stocks. Instead, the government got involved in fiscal stimulus, housing price supports, easy money, and bailouts which drove the market still higher. We should have known "fool me once shame on you, fool me twice shame on me, fool me a third time and put a straight jacket on me and have me committed." Now that this market has doubled again, we expect the decline by half again, if not more, after the technical damage of the 2009 break to new lows (below the 800 trough of 2002). The sentiment measured by Ned Davis Research (NDR) of crowd pessimism and optimism backs up the peaks and troughs we have been discussing. Periods of time where there is excess optimism are very negative for stocks, and periods where there is a lack of optimism are very positive for stocks. At the peak (in 2000) of 1550, the optimism was over 66.8 (extreme optimism is above 61.5%) at the peak in 2007 (at 1570) it was 69.2% and presently at (1405) we are at 68.2%. At the market trough of 2002 at 770 the optimism was 33.9% (extreme pessimism is under 55.5%) we were at 30.9 % in March of 2009 at 670. The latest movement up has not been confirmed by either the Transport Index or volume. We would expect this stock market to fall sometime soon if the rhythm the market has experienced over the past 14 years continues.
Fundamentals Affecting the Rhythm
As far as the economic news getting better, we suspect that the unusually warm seasonal effect had a lot to do with the comparatively good numbers. Even without the weather related comparisons, the debt always jumps out at us as the major problem. We can't imagine the U.S. will be able to escape the problems of the total debt load we have accumulated over the past 30 years. Whenever debt is mentioned almost everyone focuses in on the government debt relative to GDP. We, on the other hand, prefer to look at and analyze "Total Debt" (including private debt and the government unfunded liabilities). If you take total debt, when you have an aging demographic, and where there were promises made that cannot be kept, you will be faced with an almost unsolvable debt problem. This brings us to the problem of the promises made in health care, where the total amount of money spent for health care in the U.S. per capita is at least double every other country's and the medical outcomes are basically the same (in fact we should clearly be paying for outcomes and not procedures). The total debt has grown to over $110 trillion, which will be very difficult to accommodate since this equates to our debt to GDP ratio of over 700%.
The S&P 500 earnings (as most of our regulars viewers understand-we prefer using "reported" earnings, but since all of Wall Street focuses on "operating" earnings we will use "operating") are also just starting to show some weakness as the first quarter will be the first slowdown (earnings growth about 0.5%) in a couple of years as the profit margins were at peak levels and have always reverted to the mean in the past. Also, every single time the S&P 500 was expected to earn $100 or more, the investors were always disappointed. In fact, the 2008 earnings estimates were over $100, but when the actual number came in for "operating" earnings it was a disappointing $49.50. The 2012 earnings estimates for the S&P 500 this past fall for were up around $114, but have subsequently dropped to about $105 and will probably disappoint again. The present earnings estimates for 2013 are $119 (bottom up) and will probably be revised down sometime soon. Also, if oil continues rising, not only will earnings be affected negatively, consumer sentiment will drop and that could affect the consumer spending almost as much as the debt overload in the household sector.
We understand the jobs picture has improved, but let's put the improvement into perspective. The unemployment rate has declined to 8.3%, but at least half of the decline is explained by many of our older citizens who have dropped out of the labor force (as well as many other discouraged workers dropping out). And if we continue to generate jobs at the same rate as the past couple of years it would still take 13 years to get to full employment. Keep in mind that we have fewer jobs presently than we had 11 years ago. Housing is dependent upon a vigorous jobs market and, with all the debt the household sector has built up, we don't expect the housing market to bottom before the prices decline to the trend line of normal prices (taking out the bubble prices of housing from 2002 to 2007) and we still have 10% to 15% more decline left. The NAHB (National Association of Home Builders) February confidence index was just released at a disappointing 28, unchanged from January, and keep in mind anything under 50 is considered negative.
We are also looking at what Ben Bernanke called a "Fiscal Cliff." He was referring to the Bush tax cuts expiring at the end of the year and if they expire on everyone it will essentially be a tax increase of about $450 billion/year, or $4.5 trillion over 10 years. The payroll tax holiday expires and that could be another $100 billion/year and the "super committee" will be forced to sequester another $100 billion of spending. Also, we have the winding down of the $787 billion fiscal stimulus package that was initiated in 2009. This will turn out to be as onerous to the U.S. as the austerity programs imposed on Greece and other European countries more recently.
Europe is still not "out of the woods" since Greece probably will not be able to recover with all of the austerity imposed on them, and due to their debt load will probably have to leave the Euro Zone and could easily be followed by Portugal and possibly others. Both Japan and China are struggling. Japan has not been able to extract themselves from the deleveraging of the debt built up during the 1980s until their debt bubble burst in late 1989 (similar to the U.S. in 2000 and again in 2008). China's growth rate has been slowing since 2009 as the government has been attempting to slow the economy gradually due to inflation worries. However, the housing market has declined for the past 5 months and the government may find that it is very difficult to "fine tune" a decline, especially since it has spent 50% of its GDP to build infrastructure, housing, and office buildings (many of them empty or struggling). Confirming the slowdown in demand for copper, iron ore, and other materials, the main Chinese market is down from 6000 in 2007 to 2400 presently.
So, the bottom line is that the technical position of the market looks very weak to us (and the swings from up about 100% and down about 50% we believe will continue, with the next move down) and the global economy is not what we would call supportive to U.S. growth. Also, the U.S. debt will be an anchor around our necks until we figure out a way to grow our way out, pay it down (deleveraging), or inflate our way out. All of these solutions will be extremely difficult and painful.