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Comstock Partners, Inc.
The Shutdown And Debt Ceiling Are Not The Only Worries
October 03, 2013

The stock market appears to be on shaky ground even before considering the effects of the government shutdown and prospective debt ceiling fight.  The reasons include significant overvaluation, diminishing momentum, frothy sentiment, a continually disappointing economy, and declining earnings estimates.

In last week’s comment we detailed how the market’s price/earnings ratio (P/E) is at the high end of its pre-2000 range.  The same is true for the ratios of sales-to-earnings, cash flow-to-earnings, book value-to-earnings and total stock market capitalization to GDP.  While valuation is not a precise timing indicator, it becomes a key factor when combined with other indications that the market is dangerously high.

The technical condition of the market has deteriorated substantially in the last few months.  Momentum has waned considerably as today’s closing price of 1678 for the S&P 500 was below the intra-day high of 1687 reached over four months ago on May 22nd.  At that time new daily highs on the NYSE were averaging about 800.  When the market climbed to a new high of 1729 on September 19th, average highs were running at only about 300, indicating that an increasing number of stocks were not fully participating in the rise. It’s also noteworthy that at the May high, 90% of stocks were above their 50-day average, compared to 79% at the higher high in September.  Despite the slowdown, investor sentiment remained remarkably complacent with the Investors’ Intelligence survey showing only 19% of advisors bearish, the same as in May.

Economic growth also remains disappointing and does not appear to be self-sustaining without continual monetary stimulation that is rapidly becoming less effective.  Real consumer spending growth, on a year-over-year basis, is still at about 2% annually, where it has been for some time.  Even this paltry amount has been accomplished on real disposable income growth of only 0.8% as consumers have had to dip into their savings to maintain their standard of living.  The ADP September report showed a disappointing increase of 166,000 jobs, while the July and August results were chopped by a combined 54,000.  Both the 166,000 jobs added in September and the 3rd quarter average of 162,000 was below the 12-month average of 179,000.

Furthermore, the housing industry is starting to turn down again as a result of the sharp rise in mortgage rates engendered by the Fed’s indications of a pending decrease in their bond buying program.  Mortgage purchase applications are near their lowest levels of the year, while August new home sales were below the first-half average.  Pending home sales have declined for three straight months.  GDP, the broadest measure of the U.S. economy, grew at only 1.6% from the 2nd quarter of 2012 to the 2nd quarter of 2013, and Moody’s calculations indicate a 3rd quarter growth rate of only 1.3%, based on data released to date.

Corporate earnings, too, seem to be running out of steam.  Factset reported that 82% of companies giving guidance have reduced expected earnings, the most since they began gathering data in 2006.  According to Thomson Reuters, in the last two quarters companies reduced earnings guidance more than at any time since 2001.  We believe that this trend will continue and that current earnings estimates are far too high.

All of the above does not take into account the government shutdown and debt ceiling uncertainty that will make things even worse, the extent depending on the duration of the crisis and its eventual resolution.  The overvaluation, complacency and frothy sentiment strongly suggest that the market is not well prepared for an unfavorable outcome.  On the other hand, a relatively favorable outcome is not likely to be a big surprise since that is what most investors seem to expect.  The impression we get is that most investors think that the people in Washington are too rational to really do what they say.  Wall Street, however, does not understand Washington.  A significant bloc of Congress doesn’t seem to mind blowing up the government and, indeed, would relish doing so.  However, if wiser heads prevail, the market still has to deal with all of the other headwinds described above.  

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