Comstock Partners, Inc.September 20, 2012
The Deleveraging of the Two Most Outrageous Financial Manias in History
In this Special Report we will attempt to explain why we believe the two major peaks in the S&P 500 of 1555 in 2000, and 1575 in 2007 will not easily be surpassed, as the severe debt burdens built up in the "financial manias" preceding those peaks still must be deleveraged. We expect the latest move up in the S&P 500 from the March 2009 low will not exceed those peaks and will technically form a long-term triple top that will lead to the market declining to valuation levels similar to other secular bear market lows over the past 100 years. These valuation levels are shown on our website entitled "Limbo, Limbo, How Low Can it Go." We will also show why the debt build-up during these same manias will more than likely be deleveraged. However, it is possible that this debt could be wiped out through inflation, though we do not see this is likely since we are not getting the normal upswing in velocity from the "pump priming." We also will break down the debt into the various sectors that must be addressed to be clear about which sectors are increasing and which ones are declining or deleveraging.
Many "experts" have a year-end S&P 500 target of 1600 or above. They typically calculate this by using the consensus operating earnings estimates of about $100 for the S&P 500 by year end assuming a generous P/E ratio of 16 or more to arrive at their target.
There also have been many discussions about the potential triple top that was formed over the past couple of years when the S&P 500 reached the high 1300s to the mid-1400s. Although this triple top, according to many technicians, could form a cyclical market top, we are much more focused on the secular triple top of the dot-coms bubble in 2000 where it peaked at 1555, the housing and stock bubble in 2007 where it peaked at 1575, and wherever this last up-leg ends (we suspect this will end soon and below the past two peaks).
We think the 2000 and 2007 market peaks will not be exceeded any time soon because of the outrageous extremes that took us to those levels. The first peak occurred in what we recognized at the time was the most incredible financial mania of all time.
For the century prior to the late 1990s the S&P 500 typically peaked at 22-23 times reported (GAAP) earnings and troughed at 7-9 times earnings. During this first peak in 2000 we reached a stunning 36 times earnings (exceeding the prior peaks by about 50%) while the NASDAQ, the key driver of this financial mania, rose from 800 in 1995 to 5000 in 2000. The NASDAQ P/E ratio rose to an average of 245 times earnings after trading in a range rarely exceeding 20 times earnings from the beginning of the index in the early 1970s to the mid 1990s. After this incredible peak we expected the market to decline to a typical bear market trough valuation of 7-9 times earnings on the S&P 500 and 6% plus dividend yields when the market finally broke in early 2000. However, when the administration and the Federal Reserve could not handle the pain of allowing the market forces to decline to typical bear market trough levels, they intervened and the Fed lowered the Fed Fund rate to 1% in June of 2003 and kept them there for a year in order to stimulate the economy mainly by revving up the housing market that was the prime driver of consumer wealth in the absence of adequate increases in wages.
This reversed the housing and stock market declines from the peak in 2000 and started another outrageous "financial mania" which took the stock market back to all time highs (exceeding the peak in 2000) and generated a housing bubble that was truly unbelievable. Housing prices relative to incomes or rents rose to levels that were off the charts in comparison to any previous point in history. In order to slightly exceed the S&P 500 peak of the first financial mania (1555) the market had to go to incredible extremes by means of the Fed lowering rates, coupled by Congress (and all the politicians) attempting to get everyone in a home whether they could afford it or not. Policy makers also gave Fannie Mae, Freddie Mac, and the Federal Housing Authority (FHA) the authority to guarantee 80% to 90% of the mortgages. To make matters even worse (much worse) Wall Street packaged subprime mortgages into structured notes which they sold to their clients. Rating agencies made this all seem seamless as they gave the highest quality ratings on these structured notes. You would have to get a combination of all this insanity to get this second financial mania to exceed the peak of the first financial mania (dot coms).
Debt Generated During these Two Financial Manias and Why We expect the Deleveraging Process to Continue
First, let's take a look at how much total credit market debt rose during each mania. During the first mania (1995 to 2000) the major increase in debt came from the private side as corporations and consumers took on more debt as the stock market rose to new heights each month. The increase in net worth led to the private sector attempting to leverage the "seemingly never ending wealth accumulation" as stocks were perceived to continue rising forever. Total credit market debt increased from $15.2 tn. to $27.2 tn., even during the time that the Clinton administration was balancing the budget. So the government debt remained fairly stable as the private debt increased substantially. On the other hand, during the George W. Bush administration government debt rose as well as private debt (from $27.2 tn. to $53.2 tn.). The increase in government debt occurred as a result of the introduction of the Medicare Part D (Prescriptions), two tax reductions in 2001 and 2003 and two wars, all financed by deficits.
As you can see in the chart Total Credit Market Debt, courtesy of Ned Davis Research (NDR,) total debt rose from $4.3 tn. in 1980 to over $54.6 tn. presently. This occurred by accumulating $12 tn. of total debt during Clinton's 8 years, $26 tn. under George W. Bush's 8 years, and $1.3 tn. under Obama's 4 years. The slowdown in Total Credit Market Debt under Obama was a result of a sharp decline in private debt accompanied by an expansion of public debt by $1.3 tn. more than the drop in private debt. In fact, the government debt increased $1.6 tn. under Clinton, $5 tn. under George W. Bush, and $5.3 tn. under Barack Obama.
As you can see from the math, it is clear that as total credit market debt grew since 2008 by only $1.3 tn. and the Government Debt rose by $5.3 tn., total private debt had to decline by $4 tn. We will end this deleveraging aspect of the U.S. Debt by focusing in on the household sector of the private debt in the last section, since the household debt is such a significant part of the U.S. economy.
Household Debt and the Significant Decline (Deleveraging)
The main sector of debt that has to be addressed is the household (H/H) debt which rose every single quarter from the period at the end of WW II until mid 2008 (a total of 250 quarters), until the latest financial crisis hit. Since that time the H/H debt has declined for the past 16 consecutive quarters. The major question will be just how that debt is handled. If it continues to decline to levels typical of the past relative to personal disposable income (PDI) and GDP, the current $13 tn. of H/H debt will have to decline to between $8 tn. and $ 9 tn. If H/H debt does continue declining and breaks down below $10 tn., it will be very detrimental to the U.S. economy since consumer spending makes up over 70% of GDP.
In summary, we are convinced that the two significant peaks (1555 and 1575 on the S&P 500) reached after the worst two financial manias of all time will not be exceeded for many years, even though the S&P is now within 100 points of these peaks. We also believe the private debt generated during the manias will continue to be deleveraged as the economy struggles. It is hard to believe the economy will be able to rebound since the excess H/H sector debt will continue to restrict consumer spending. When the H/H debt is so much higher than the norms relative to PDI and GDP and the deleveraging is already underway, the best scenario possible is very slow growth and the worst scenario is a depression. And with an environment like this-- owning stocks is as close to being insane as was holding them at the end of the dot com bubble and the housing financial mania.