Comstock Partners, Inc.October 11, 2012
The Bad News Has Not Been Discounted
The market is facing severe headwinds in the period ahead and is showing early signs of topping out. Recently, there have been seven distribution days on the S&P 500 and NYSE and five on Nasdaq, a signal usually indicating a market decline ahead. A distribution day occurs when an index is down for the day on increased volume. A number of leading stocks have broken important support levels, particularly in the benchmark technology sector. Nasdaq has broken below its 50-day moving average and stocks have generally been selling off late in the day, a sign of institutional selling. Significantly, the S&P 500 high was made right after the Fed's announcement of QE3, indicating a typical buy on the rumor, sell on the news event. Furthermore, this action must be seen in the light of a market that has already discounted a lot of good news, both over the last three years and the last three months.
The technical deterioration is supported by the fundamentals, which reflect an anemic U.S. recovery, dysfunction in Washington, the coming fiscal cliff, a European sovereign debt crisis and recession, ongoing problems in Japan and a significant slowing of growth in China and other emerging nations. (Please see our recent comments). In addition, S&P is now projecting consensus third quarter earnings estimates at 2.7% below a year earlier, the first decline in three years. Already, we have seen disappointing revenue and earnings estimates for key companies at the heart of the economy such as Alcoa, Chevron, Cummins, Caterpillar and FedEx.
While these problems are fairly well-known, they have not really been factored into the market since investors have been focusing on other factors that they regard as highly bullish. First, they see the Fed and central banks throughout the globe as being highly accommodative. Not only that, but investors seem to feel that the central banks have everything under control and will prevent anything terrible from happening. Second, since other investment choices offer little prospect of returns, they believe that the stock market is the only game in town. Third, the fourth quarter is usually beneficial for stock market gains. Fourth, most observers believe that the market is undervalued. Fifth, they cannot believe that Congress will be so irresponsible that they will not solve the fiscal cliff.
We disagree. While the Fed is accommodative, they have already done all the conventional easy stuff. Short-term rates are near zero, long-term rates near historical lows and the Fed's balance sheet at astronomical levels What they are doing now is unconventional, untried and subject to unintended consequences. While investments other than stock offer little or no return, investors have shown throughout history that when everything hits the fan, they choose to protect their assets rather than lose them. While fourth quarters have tended to be strong, the tendency is statistically weak and often overwhelmed by other factors. In addition, stocks are far from undervalued, and are selling at 18.4 times smoothed reported (GAAP) earnings, compared to the long-term norm of about 15.
As for the fiscal cliff issue being settled because it's the responsible thing to do, we'll go along with Alan Simpson, who said today that "They really believe honestly that no congress can be this stupid and, by God, they can.!"
All of the above should be seen in light of our long-time underlying theme that a debt bubble followed by a credit crisis leads to a deflationary recession or depression, and a major secular bear market. We think that the forces behind debt deleveraging have more firepower than all of the world's central banks and governments together. In sum, we believe we have reached a point where all of the good news has been discounted and the bad news ahead has not. In recent weeks the market has begun to reflect this outlook.