Comstock Partners, Inc.November 08, 2012
Back To Reality
Although everyone knew about the bad news facing the market, it was essentially ignored until the September 14th high, when stocks started to trend downward on the day after the announcement of QE3. This trend has now accelerated upon completion of the long election campaign as the negative news has now come to the fore in spades. The list includes the anemic U.S. recovery, the dysfunction in Washington, the coming fiscal cliff, the European sovereign debt crisis, ongoing problems in Japan and a significant slowing of growth in China, India and other emerging nations.
In addition, the earnings support for the market is deteriorating rapidly. Only about 37% of S&P 500 companies have beaten 3rd quarter revenue estimates and three of four companies have guided earnings estimates down for the 4th quarter. In fact, 4th quarter earnings estimates have dropped 2.3% since the start of the earnings season, and that was only about four weeks ago. These trends are likely to continue well into 2013, indicating that estimates will probably be revised down substantially.
With the elections out of the way, investors are suddenly showing great concern about the fiscal cliff that they have known about, but chosen to ignore, since mid-2011. The effects of going over the cliff are so dire that the various parties will probably come up with some sort of compromise, although this is far from certain. President Obama has dawn a line in the sand stating that he will veto any bill that doesn't include a tax increase for high income earners while the majority of Republicans have signed a pledge that they will not increase taxes whatsoever. However, even if the fiscal cliff is temporarily avoided, any compromise will have to include some combination of tax increases and lower spending that will still shave something off GDP in 2013.
The key takeaway, though, is that even if the fiscal cliff issue is fixed temporarily, all of the economic problems facing the U.S. and the rest of the world remain. As we have stated ad infinitum, the underlying problem holding back economic growth is the high level of household debt. In our view household debt deleveraging will hold back the economy for the next few years as the buildup of debt during the dot-com years and the housing boom is corrected. Borrowers, faced with minimal wage increases, leveraged the value of their homes and slashed their savings rates to maintain their standard of living. When the double booms collapsed consumers no longer had their inflated asset values, but the debts remained.
While we don't underestimate the dangers of rising health care costs, unsustainable Medicare and Social Security obligations, a deteriorating infrastructure and declining education quality, it is the deleveraging happening right now that is dampening growth. Although consumer spending has rebounded slightly in the last two or three months, it has been almost entirely as a result of the savings rate dropping from an inadequate 4.4% in June to an even more paltry 3.3% in September while income growth remains too low to support robust spending.
The task ahead is extremely difficult. Household debt peaked at 129% of disposable personal income during the housing boom compared to a 60-year average of 76%. While the ratio has now declined to 109% there is still a long way to go. Just to get back to the ratio of 90% that was registered in 2000 would entail a decline of 10% in consumer spending from current levels. While this would obviously not happen all at once, we can see that such deleveraging will exert a meaningful drag on the economy for some time to come no matter what monetary and fiscal policies are in place.
In our view the market has probably made a cyclical top within an ongoing secular bear market as the problems that have been ignored for some time are now receiving recognition. The S&P 500 has now declined 6.6% from its September 14th intraday high where it is now resting at about the 200 day moving average. Significantly, the Nasdaq and Dow have already broken that key level. While short-term rallies are likely, we believe the market has a long way to go on the downside.