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Comstock Partners, Inc.
June 01, 2017

As the U.S. stock market continues to make new all-time highs it may appear to many investors that valuations no longer matter.  We do not see it that way now, nor have we ever in the past.   We maintain our long held belief that the U.S. stock market is extremely overpriced, relative to past earnings and future earnings prospects.   This overpricing is the direct result of the largest financial experiment in history, i.e., the growth in the Fed’s balance sheet from $800bn. to $4.5tn. and the setting of the overnight Fed Funds rate to near zero from December of 2008 to December of 2015.  Today, eighteen months after the first rate increase in seven years, the daily effective Fed Funds rate typically comes in at a mere 91 bps.  We have repeatedly referred to this period as the “Central Bank Bubble”, as asset values have inflated.

By growing its balance sheet and keeping interest rates low, the Fed reasoned asset prices would be backstopped and stimulated.  The increase in asset prices would create a “wealth effect” as those in our society, fortunate enough to own these assets, would feel wealthier and spend money.  This, in turn, would result in economic growth that would benefit society as a whole, including those at the bottom end of the economic ladder.  The result has not been what the Fed intended, and in fact, has caused some unintended consequences.  The economy has grown at the most anemic rate ever, around 2% per year, when recovering from any recession.  Wealth disparity in our society is at an all-time high.  At the same time, by many different valuation metrics, the stock market is near or in excess of the highest valuations in history.  As of this writing, the trailing 12 month P/E based on generally accepted accounting principles (GAAP) is approximately 24.2, a historically very high number when the economy is not in a recession and earnings have already dropped more than prices.

We believe that in the long run, corporate earnings should grow about as fast as the economy.  The stock market, in our view, is imputing a higher growth rate to future earnings than we think is likely, or even possible, for the following reasons:

  1. We believe that the debt outstanding in the US, which consists of federal, state, local, corporate, household, and student loans, has been a major factor in the anemic growth of the past several years.  This number currently stands at $66tn, or about 330% of GDP.   The servicing of this debt diverts resources from otherwise productive uses.  In addition, given the artificially low level of interest rates, the exposure to rising rates is enormous and a major risk that is not, in our view, universally appreciated.  There is also the non-trivial matter of the unwinding of the Fed’s balance sheet.  Selling bonds in the market does not appear to be a consideration as that could cause a stampede out of fixed income markets here and around the world.  We would like to point out that the “running off” of the balance sheet (letting bonds mature) is another “experiment”.  In addition, estimates of the size of the U.S. government’s unfunded liabilities and entitlements range from $80tn. to $150tn.; and that is not even in the above numbers.  (More on this below.)

  2. The ECB, BOJ, and BOE have also adopted “whatever it takes” policies.  They too have greatly expanded their balance sheets and have even “upped the ante” with previously unheard of negative interest rate policies.  Because of the liquidity of currency spot and forward markets, much of that money has come into the U.S. to “chase yield”.  This has further inflated and distorted asset prices in the US.  Also, the world’s second largest economy, China, has inflated a credit bubble with breathtaking speed that, relative to its banking system, is the largest in the world.  All of this further adds fuel to the worldwide credit bubble fire.

  3. The growth rate in GDP is a function of the change in total hours worked and the output per hour.  With the economy at, or near, full employment there is not much room for growth in the total hours worked.  In addition, we are now at the point that the “baby boomers” are retiring at the rate of about 10,000 people per day, while new workers entering the work force number much less than that.  Immigration of skilled workers could potentially help the problem, but thus far we see no rush on the part of the Trump administration to address this meaningfully.

  4. On the productivity side, the alarm was recently sounded by former Fed Chairman Greenspan.  He contends that the growth in entitlements has crowded out savings, which in turn, means less capital flowing into productive assets.  He calls entitlement reform the third rail of US politics as our leaders are afraid to confront the problem head on, for fear of being voted out.  We completely agree. 

Thus, given the level of debt and commensurate interest rate exposure, along with negative population demographics, and the lack of addressing entitlement reform as it relates to long term productivity growth, it is our strong belief that the US economy will not grow at rates that will vindicate current equity market valuations.  We remain committed to the thesis that the experimental Fed policies of the past years have inflated and distorted equity and other asset prices tremendously (while generating “unintended consequences”).

In our view, this time is NOT different.  Ultimately the stock market will reflect an economic reality much different than it does currently.  When that happens, as in past times when bull markets ended, stocks will likely fall much faster than they went up. 

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