Comstock Partners, Inc.May 05, 2015
The Debt, ZIRP, and Valuation
As we write the US stock market, as measured by the S&P 500 and Nasdaq Composite Index, hovers at or near new highs. We will take this as an opportunity to reiterate that this is a bubble that is the direct creation of the Federal Reserve. We continue to refer to this phenomenon as the “Central Bank Bubble”.
Just under one year ago, analysts were estimating S&P 500 operating earnings to increase for the first quarter of 2015 by over 10%. That number is now substantially lower and has gone negative for the entire index. According to “FactSet Earnings Insight”, both Q1 and Q2 2015 earnings are now expected to be lower. Through May 1, the blended result of companies that have reported and have yet to report for Q1 2015 stood at -.4%. Analysts are in fact expecting year over year declines through Q3 2015 but are then expecting a strong rebound in Q4 2015. We agree with the former and strongly disagree with the latter. But whether attributed to weather, the west coast port strike, or dollar strength, the fact remains that for whatever the reason, two declining quarters constitutes an “earnings recession”. We have had 13 “earnings recessions” since 1945, and all but three of those have led to an economic recession. We continue to believe corporate earnings will not grow as a whole at a meaningfully different rate than US Gross Domestic Product (GDP), as corporate earnings are a proxy for economic growth. Growth in the economy, in turn, is heavily influenced by “Total Credit Market Debt”, which is the sum of government, corporate and household debt.
Only at the time of the great depression of the 1930’s has “Total Credit Market Debt” been greater than 200% of GDP in the United States (see attached chart from Ned Davis Research)). That is, of course, until the middle 1980’s when this metric again penetrated that barrier. After that time it went on an inexorable march to a whopping 367% of GDP just prior to the bursting of the “Housing Bubble” and stood at just under 332% as of the end of 2014. The level of debt continues to be a headwind to economic growth that will persist until the debt is paid down.
What has acted to somewhat mask this headwind is, what we believe, is the most reckless policy ever adopted by the Fed. The Fed was wrong on the “Dot Com Bubble”; was wrong on the “Housing Bubble”; and we believe will be wrong in the creation of the current “Central Bank Bubble”. This Fed is in a major experimentation mode which is very dangerous. The policy of which we speak is, of course, Zero Interest Rate policy, or (ZIRP). This policy has driven the Fed’s Balance Sheet from $800 billion in 2008 to $4.4 trillion currently.
It is because of ZIRP that stocks do not appear, to some, to be expensive. After all, if the alternative is a 2% ten year treasury or 2.6% thirty year treasury, maybe a 2% dividend yield isn’t so bad; or so the thinking goes. But as stated above, the growth in corporate profits in the long run is a proxy for the growth in the economy, or GDP. And right now stocks, measured by market capitalization, are near the highest they have ever been relative to GDP. Every major market bottom and top has been coincident with very low or very high ratios of “Stock Market Capitalization to GDP”(see attached chart from Ned Davis Research). It is likely the reason is that this metric has purported to be a favorite of Warren Buffet. In fact, the only time this metric has been higher was just before the” Dot Com Bubble” burst. It comes at a time when deflation is playing out all over the world. The dollar is strengthening, which hinders multinational companies from exporting goods abroad. In addition, it appears that companies do not have enough pricing power to increase margins.
We at Comstock have been telling our viewers that we have been in a deflationary environment for years. It seems the markets now are agreeing with us as there are currently few countries that are expecting any material inflation over the next ten years. This is evident by the yields in ten year sovereign paper. The following are yields as of the date of this writing: United States 2.19%; United Kingdom 1.97%; Italy 1.81%; Spain 1.78%; France .82%; Japan .36%, and Germany .52%.
What all of these countries have in common, in addition to being democracies, is that their respective central banks are in a “Liquidity Trap” situation, where low and even negative interest rates do not encourage consumer spending but rather consumer savings. Businesses in turn do not have the confidence to invest in new plant and equipment. This is particularly true in the United States, where the average age of private fixed assets is the oldest in the past fifty years.
So, to our viewers we say, we have been early on this, as we were with the Dot Com and Housing Bubbles, but we are confident this will end the same way as those bubbles. The US stock market is historically expensive and financial assets have been inflated by an experimental central bank policy. It is an error that is now being repeated by central banks in Europe, Japan and just recently, China. These markets are being influenced in similar ways as ours, rather than fiscal and tax policies that would stimulate sustainable growth. We will hold our view that stocks are expensive until they become priced more reasonably relative to the growth prospects of the economy. We have maintained consistently that high levels of debt are the main problem affecting growth and those debt levels will not be going away any time soon.