Comstock Partners, Inc.November 14, 2013
The Same Old Speculation In A New Guise
The market continues to rise solely on the perception that the Fed’s easy money policy can hold stock prices up indefinitely. We think that this line of thinking will prove to be no more durable than the dot-com bubble that peaked in early 2000 or the housing bubble that topped out in late 2007. In both cases the market gave back a large proportion of the gains made during the bull market, and we believe that will prove to be the case this time as well. When the vast majority of investors faithfully believe in a bubble, momentum takes over and the market goes up because it’s going up, ignoring all of the obvious warnings such as high valuations, over bullishness, decreasing earnings momentum and an underperforming economy. When reality suddenly sets in, as it inevitably does, most investors are left holding the bag, hoping that the market doesn’t go any lower.
The housing boom market of 2006 and 2007 provides the most recent example of the persistence of bullish momentum and irrational belief in the face of obvious negative events that were ignored in the frenzy to join the bullish crowd. As early as August 2006, various mortgage lenders began to go public with their dire problems. H&R Block’s subprime lending facility had to set aside $60 million due to borrowers falling behind in payments. Countrywide Financial publically stated that customers were slow in paying their loans. Similar statements were made by mortgage lenders Impac Mortgage and Accredited Home Lenders. Washington mutual revealed that, as a result of improper calculations, it had made loans to borrowers at lower rates than their personal situation justified. The unpaid balance of these borrowers was $30 billion. It shouldn’t have taken much imagination to realize that these revelations were only the tip of the iceberg, and that there was much more to come.
Now remember, the above revelations occurred in August 2006. The stock market kept rising for another 14 months to October 9, 2007. During these 14 months, new revelations came out almost daily, detailing the full implications of the crisis that was enveloping us. We learned how mortgages were sold and packaged, sliced and diced, and sold all over the world. We learned about an alphabet soup of various types of securities few had ever heard of before. On February 8, 2007, a Wall Street Journal article stated that “The mortgage market in the U.S. is a complicated web of mutually dependent businesses. Mortgages are bought and sold several times over, and the default risk often lands far from the institution that originated the mortgage.” The press was full of announcements of mortgage companies taking huge write-downs and going out of business.
Things got even worse in June 2007, when two big Bear Stearns hedge funds came close to collapse. Despite all this, Wall Street still didn’t get it. As late as August 2007, a guest on financial TV casually referred to the turmoil as “financial gamesmanship”, as opposed to what he termed “solid economic fundamentals”. He was far from alone in his thinking, as the market rallied for another two months before peaking.
Looking back, the market not only ignored the early warnings of some very prominent people and institutions, but, even when faced with the reality of events, continued to operate in a state of denial.
The current market delusion is not about the dot-coms of 1999-2000 or the housing boom of 2006-2007, but about the blind faith in the ability of the Fed to hold up the market for an indefinite period in the face of a faltering U.S. economy, global weakness, decelerating earnings gains, significant overvaluation, overly bullish sentiment and the dysfunction in Washington. Although the bulls, as usual, say “this time it’s different”, there is nothing new in the market's historical cycles between greed and fear. In the end, there is only the same old excess speculation in a new guise.