Comstock Partners, Inc.January 17, 2013
Market Strength Based On Dubious Assumptions
Despite the problems facing the U.S. economy, the dysfunction in Washington and slowing global growth, stocks continue to rise on the basis of what we view as false assumptions. These assumptions are as follows:
1) Since almost every central bank in the world is aggressively easing, the market cannot go down.
2) Although the U.S. is facing a fight in Washington over the debt limit, the sequester and the expiration of the annual federal appropriation, various political threats over the last two years have passed without substantial market damage, and the same will happen this time.
3) S&P 500 earnings will rise to $108 in 2013, resulting in a current P/E multiple of only 13.7.
4) The economic recovery will kick into full gear once the problems in Washington are solved or again "kicked down the road."
We disagree. Despite massive ease by the Fed and stimulative fiscal policy, the economy has grown at only a 2.2% annualized rate since the recovery started in the 2nd quarter of 2009. That pales in comparison to the average of 3.6% between 1950 and 1999----and that period included both recoveries and recessions. The Fed, however, has run out of ammunition. The funds rate has been near zero since 2008 while each successive round of quantitative easing has had less and less effect. GDP estimates for the 4th quarter of 2012 are only between 0.5% and 1.5%. Economic growth has shown few signs of being sustainable on its own. It is worth pointing out that GDP growth has consistently been overestimated throughout the recovery. The Fed, for instance, originally forecast GDP growth of 4.5% for 2012.
Moreover, fiscal policy, which has previously been supportive of economic growth, is fast becoming a headwind instead. The fiscal cliff agreement, although celebrated by the market, raised taxes and reduced spending by enough to slice between 1% and 1.5% off GDP this year. No matter how the upcoming debates are resolved, they are all about cutting deficits through some combination of spending reductions and tax increases. A portion of this will be applicable to 2013, and result in additional deductions from economic growth.
In our view S&P 500 earnings for 2013 will come in far under the $108 forecast by the consensus. Earnings in the 3rd quarter were substantially under predictions made earlier in the year while revenues were about flat year-over-year. The 4th quarter results are likely to be no better. Furthermore, cyclically smoothed reported (GAAP) earnings are only at about $75, meaning that the market is significantly overvalued, rather than cheap.
Investors are also ignoring the headwinds from slowing growth or recession across the globe. Europe and Japan are in recession while China is slowing down, meaning that the export-dependent emerging economies will be hit as well. The new Japanese government has now taken actions to devalue the yen in order to increase exports. This is already increasing the strength of the euro to the consternation of the EU, which is likely to take action to defend its currency. The potential result is a global currency war in which everyone loses.
Investors think that once Washington gets its act together the economy will be off to the races. We doubt that will be the case. For about 25 years consumers binged on debt and reduced their savings rates as real household income stagnated. We are now in a period where consumers will be paring down debt and raising savings rates, resulting in tepid spending at best for some time to come. In this kind of climate capital expenditure growth will also remain sub-par in response to lack of demand for products and services.
The cyclical bull market is now almost four years old and is close to the historical average in terms of both amplitude and duration. At this point it is out of sync with economic growth and valuation, and the risks seem far greater than the potential rewards.