Comstock Partners, Inc.October 17, 2013
Not Falling Off A Cliff Is No Reason For Optimism
Although the sigh of relief that the nation wasn’t going to default today was worth a short bounce, the outlook for additional stock market gains seems bleak. The agreement to open the federal government and raise the debt ceiling temporarily is a Band-Aid rather than a solution, and merely sets up the prospect of another confrontation within a short time. Meanwhile, an economy that was already sputtering before the negotiations even started has now undergone further significant damage. We see the following serious problems with the near-to-intermediate outlook.
1) The agreement settled nothing, and we will now be doing the same thing over again within a short time. The settlement called for the formation of yet another congressional committee to either come up with a long-term budget solution or a budget for fiscal 2014 (ending September 30, 2014). The problem is that we’ve tried this over and over again, and, if anything, positions have hardened. The House budget resolution proposes deep spending cuts and no tax increases, while the Senate resolution includes large tax increases and less spending cuts. Both sides are adamant in their positions, and are unlikely to work out a compromise by December 13th that they have rejected numerous times in previous negotiations. Absent an agreement, we will be facing another bitter conflict as we approach January 15th.
2) Part of the reason for the market’s optimism is the likelihood that the Fed’s tapering will be now put off to at least March as a result of the additional economic uncertainty created by the current deal. However, quantitative easing (QE) has been priced into the market over and over again, raising the question as to how many times the market can discount the same factor. In addition there is a serious question on whether the benefits of QE outweigh the possibly serious unwanted side effects.
3) With the economy barely growing, corporate revenue growth has been decelerating while profit margins are 70% higher than their long-term average and likely to come down. As a result, earnings growth is also slowing, and current forecasts will probably prove to be far too high.
4) Economic growth was only in the 1.5%-to-2% range even before the recent round of negotiations, and is now likely to sink below that. While lower government spending during the shutdown probably only sliced about 0.2% annualized from 4th quarter GDP, the effect on consumer and corporate spending can lop off anywhere between 0.2% and 0.7% more. And the uncertainty leading into the January 15th deadline can affect 1st quarter growth as well.
5) Most market strategists seem to assume that other than the turmoil in Washington, the underlying economy is getting stronger. We’d like to see their data. Real consumer spending on an annualized basis increased by a tepid 1.5% in the 1st quarter, 1.2% in the 2nd, and 1.3% in July and August. That’s barely above recessionary levels. In addition housing is slowing down, business remains reluctant to hire and spend, and government spending is declining. Furthermore, if the budget committee comes up with an agreement, it will almost certainly involve additional cuts in spending and, perhaps, higher taxes. If there’s no agreement, the sequester is scheduled to increase automatically in January.
6) A last minute settlement is what the consensus expected, so was not a great positive surprise. The market’s maximum decline was slightly under 5%, meaning there were few outstanding bargains available as result of any jitters during the conflict.. The preponderance of sentiment is dangerously bullish and the S&P 500 is selling at an historically high multiple of 19 times trailing reported earnings. In our view, the current condition of the market is eerily similar to the peaks of early 2000 and late 2007, when unfavorable conditions were ignored by the majority of investors.