Comstock Partners, Inc.August 15, 2013
The Stock Market Trend Is Turning Down
The market was hit hard from all directions today. Major company reports indicated more economic weakness ahead at the same time that the prospective tapering of QE became more imminent. The ten-year bond rate took another leap higher in response to lower unemployment claims despite WalMart and Cisco joining Macy’s in forecasting lower revenues in the second half. This was enough to cause the market to plunge down through its near-term S&P 500 support of 1676 on volume that, although still low, was solidly higher than the previous day. It is now likely that the market has begun a new major down leg. We cite the following factors, many which have been around for a while, that now seem to be coming to a head.
The 10-year rate has jumped from 1.6% to 2.8% within a relatively short period of time in response to the prospect of Fed tapering, indicating that the bond market caught on to its negative implications quickly while stocks have been slow to react until very recently. The interest rate rise has increased mortgage rates significantly and will impact consumer borrowing rates for durable goods such as autos.
Asset values such as stocks and real estate have become increasingly dependent on QE for growth in the absence of a self-sustaining economic recovery. With earnings growth having leveled off, the seemingly open-ended QE has been virtually the only factor holding up the market. The market similarly soared during QE1 and QE2, and corrected after they ended, only to be bailed out by QE3 and QE4, which deliberately had no definitive ending date. Now that the ending date of QE4 is no longer infinite, the market is likely to act as it did in anticipating the end of the prior QE programs.
Even with QE in effect with no known ending date, economic growth remained stuck at an inadequate 2% on average, and has not been picking up. Consumer spending, accounting for about 70% of GDP, has been hampered by deleveraging as well as barely growing disposable income. Reports by WalMart, Cisco, Macy’s and others indicate that forecasts for a second half pickup in growth are highly doubtful. Auto sales returned to pre-recession levels by last November, but since then have been about flat. Housing appears to have stalled since the 10-year rate started to rise. Single-family housing starts have declined over the last three months while MBA purchase applications have dropped to the lowest level of the year as the rise in home prices and mortgage rates have led to a sharp rise in prospective monthly payments.
The Fed’s desire to taper QE is therefore not being spurred by a stronger self-sustaining economy. From minutes of the FOMC meetings, Bernanke’s press conference and various speeches by Fed members, it seems apparent that they are concerned QE is becoming less and less effective with the passage of time and that the potential negative side effects are increasing. While the goal has been to raise asset values by enough to have the so-called wealth effect spread to the economy, it has not happened, and they are increasingly worried about how they are eventually going to pare down the Fed’s balance sheet that has soared to unheard of levels.
Adding to the problem is the coming clash in Washington over the Federal budget and debt ceiling, with a strong faction of the House talking about closing down the Federal government. Although it probably won’t happen, the fight will be accompanied by a lot of intense conflict, political posturing and scary headlines that investors won’t like.
The steep market rise since March 2009 is long in the tooth and valuations have been stretched to highs that equal every major market top since 1929 with the exception of the bubble highs in 2000 and 2007. Similar to the 2000 dot-com peak and the 2007 housing boom peak, the current market is based on the QE bubble rather than the economy.
Technically, when the market broke above its previous high of 1687 on the S&P 500, it stopped at 1709 and has since broken down into its previous zone, negating the validity of the breakout. Notably, average daily new highs on the most recent top were only about 400, compared to 800 on the prior peak, indicating deterioration in market action. In addition, as we mentioned above, today’s downward move broke down through a key short-term resistance point. In sum, we believe that this is the probable start of a major down leg in the market.