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Comstock Partners, Inc.
December 31, 2014


We write to reiterate that the United States and other major stock markets are in what we have termed the “Central Bank Bubble”.   In December, the U.S. stock market staged a furious comeback rally following a rapid and substantial decline.   Just prior to the latest upturn, the market seemed ready and poised for further and even more substantial declines.  The rally appears to have been precipitated by the Fed substituting the word “patience” for “considerable time” in their latest policy statement.  While we were disappointed that the markets rallied based on the simple parsing of words, we remain convinced that deflation, overvaluation, and Fed policy in response have intertwined to cause one of the largest stock market bubbles in history.   

We see nothing that would cause us to change our opinion.  Let us once again point out the near zero interest rate policy and three quantitative easings (along with operation twist) that have not only expanded the Fed balance sheet to unprecedented levels but have thoroughly distorted our capital markets.  With returns to investors in money market funds at zero, investors have had to chase yield in both the stock and bond markets.   A glaring example of capital market distortion is at the sovereign level where the US 10 year Treasury yields 2.16%; while Portugal's 10 year trades at 2.76%,  Italy trades at 1.92%, Spain at 1.63% and Germany at .54%.  A further example of distortion caused by zero rate policy is near record low yields in US Corporate Bonds combined with record high issuance; now over $2tn. for three years running.   Much of the debt sale proceeds have been used to fund share repurchases, which in our view has artificially propped up earnings, while leaving corporate balance sheets more leveraged and revenues lagging.

Importantly, the velocity (turnover of money) of the M2 money supply has remained near the lows of the past 60 years.  That statistic serves as proof that the Fed’s efforts are getting very little “bang for the buck”.  We also observe that the several different commodity price indexes declined to their lowest point in the past 5 years and shows no sign of bottoming.  And as you all know energy prices have been collapsing, as supply is overwhelming demand--many think that energy prices are holding back the U.S. bull market by hurting other countries abroad. Soon they will realize that the commodity price decline (see attachment) is caused by the global distress--not the other way around. For example, Europe will be attempting to do whatever it takes to prevent more deflation with a vote to start a new QE policy at the January 22nd ECB meeting.  Japan is lowering corporate taxes to try to exit 25 years of deflation, and China is trying to prevent a credit bubble crises now that they are no longer the growth engine of the world.  And while they are attempting to move from an exporting led economy to a consumer led economy, in the face of a property overhang.  There are many more examples of stress in the global economy. 

The Fed is about to raise interest rates sometime in 2015 (for the first time in 6 years), and that could be trouble for stocks just as it was after the ending QE-1, and QE 2.  On the other hand, if they don’t raise rates it would only be based on failed QE policies that were supposed to revive the economy.  This is the incredible dilemma that the Fed faces in the coming year.

All of the aforementioned factors are screaming "deflation". Thus far the market has not heard the message.   But we are convinced that it will be heard, and when it does, we believe the U.S. stock market will decline precipitously (see Cycle of Deflation attachment).  

With that being said, we still wish all of you a Happy and Prosperous New Year!

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