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Comstock Partners, Inc.
A Topping Pattern In The Market Is Underway
April 04, 2013

The market appears to be running into some technical problems at the same time that the fundamentals are showing sign of deterioration.  Recent U.S. economic releases have tended to be disappointing, while the global economy is either in recession or reporting slower growth.  At the same time the situation in Cyprus is still festering, Italy is without leadership, North Korea is making serious threats and the Mid-East is----well, the Mid-East.  Japan is embarking upon unprecedented massive easing that is most likely to set off a global currency war to see who can devalue faster.

The market is showing signs of divergences that usually show up at market peaks.  The Russell 2000 has been underperforming the S&P 500, market breadth has begun to erode, new daily highs in stocks are diminishing and transports are lagging.  In addition investor behavior is signifying a flight to safety as the strong performers have been defensive stocks such as consumer non-durables and health care, while cyclicals, commodities, banks and brokers have been lagging. 

The economy also appears to be cooling off after a decent start to the year.  Weekly unemployment claims jumped to 385,000 compared to estimates of 347,000.  The ISM manufacturing index dropped to 51.3 from the previous month’s 54.2 and estimates of 54.  The ISM non-manufacturing index declined to 54.4, its lowest number since August.  The ADP employment report dropped to 158,000 compared to an estimate of 215,000.

Real consumer spending has been growing at a mediocre 2% rate over the past year, outrunning the weak 0.9% growth in real disposable income over the same period.  To accomplish even this meager growth rate, consumers had to drop their savings rate to an extremely low 2.6% in February.  It is highly likely that consumer spending will slow down even more.  Employment growth is diminishing and the negative effects of the January tax increases and the sequester have barely begun to kick in.   

According to William Dudley, the head of the Federal Reserve Bank of New York, “The increase in payroll tax, the rise in high income tax rates, the increases in taxes associated with the Affordable Care Act, and now the sequester----if sustained----will result in fiscal drag of about 1 ¾ percentage points of GDP in 2013….in an ideal world, fiscal policy would have broad-based bipartisan support.  That would reduce uncertainty and reassure households and businesses that the U.S was on a sustainable long-term path.  Instead, we have nearly the opposite:  significant retrenchment in the near-term, but no credible action over the long-term, with partisan divisions and significant uncertainty about what will happen next.”

Adding to the global problems, the Japanese central bank has announced its intention to begin a massive and unprecedented easing program with the aim of doubling central bank assets within two years and increasing the inflation rate to 2% after more than 20 years of deflation.  The plan is to buy the equivalent of $75 billion of various types of securities each month compared to the U.S program of $85 billion---and keep in mind that Japan’s economy is only one-third the size of the U.S.  One important result will be a significant devaluation of the Yen in attempt to make Japanese goods attractively priced in world markets.  The problem is that other nations will also have to attempt devaluation in order to protect their economies, resulting in a deflationary global currency war that we at Comstock have long anticipated (Cycle of Deflation-attached).  

All in all, we believe that the cyclical bull market that started four years ago has run its course and that it is now in the process of topping out.  The consensus does expect a minor correction, but is eagerly looking forward to buying “bargains” on the dip.  However, the first downturn in a new bear market is usually indistinguishable from any run-of-the-mill correction.  It is only after the first rally attempt fails that the reality of a new bear market begins to sink in.  While the topping process may take some time, we think a major downturn is in store.

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