Comstock Partners, Inc.December 05, 2013
Summary--Why We Are Still Bearish
The following comment brings together in one article the various themes we have been writing about weekly, and emphasizes why we are maintaining our bearish position at a time when so many bears have thrown in the towel.
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 concept, no matter how faulty it may be, 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.
Some market observers maintain that all of the talk we hear about a “bubble” means that we aren’t in one. However, we would ignore all of the talk on Wall Street and in the media about whether the stock market is in a bubble. After all, that’s just a matter of semantics, and whatever we call it, the market is overvalued, overbought, and overly bullish at a time when the economy is slogging along at an inadequate pace, and depends almost solely on the prospect of continuing Quantitative Easing (QE) to continue its upward move.
The market doesn’t have to be in a bubble in order for it to be on the precipice of a significant decline. Of all the cyclical market peaks since 1929, only the tops in 2000 and 2007 were looked back on as being bubbles. Most of the other major market peaks occurred with the P/E ratio ranging between 18 and 21 times reported cyclically-smoothed GAAP earnings, compared to a norm of 15 times and bear market lows between 7 and 10 times. The current P/E ratio of 20.6 times earnings is high enough to be a potential market top, especially given existing fundamental and technical conditions. The similarity between now and 2000 or 2007 is not necessarily that we are in a bubble, but that the reason for market strength rests on such dubious grounds.
In our view, the market is not supported by strong fundamentals. The so-called strength in the economy is based on forecasts, rather than on current conditions. But forecasts have now been overly optimistic for the last three years, and we see no change in the period ahead. The revised 3rd quarter GDP growth of 3.6% annualized is far from indicative of renewed economic strength as 1.7% was accounted for by increased inventories, meaning that real final sales were only growing at a still tepid 1.9%. And even taking the top-line number at face value, GDP has been growing at only 1.8% over the past year.
Similarly, both real consumer spending and real disposable income have been rising at a weak 1.8% rate----and this with a powerful dose of QE. Core capital goods orders for October dropped 1.1%, and have now declined for three of the last four months. With the rise in mortgage rates, housing has also become a weak spot. October existing home sales were down 3%, while the pending sales index, which leads existing sales, indicates more declines ahead. With consumer spending, capital expenditures and housing accounting for over three-quarters of of the economy, the recovery is not likely to become self-sustaining for some time to come.
While it is difficult to estimate what the rate of economic growth would have been without Quantitative Easing, it is clear that the vast amounts added to the Fed’s balance sheet have barely trickled into the real economy. The growth of the money supply has been relatively low compared to the amount of Fed bond purchases (the multiplier). In turn, the growth of the economy has not been proportionate to the increase in the money supply (velocity).
Technical conditions also point to a vulnerable market. Breadth has been narrowing and did not confirm the recent new highs in the averages. Daily new stock highs peaked in May and recently have been trending lower. The Russell 2000 has been lagging the large-cap averages. Some speculative high-P/E momentum stocks have recently been hit hard. Investors Intelligence bulls have averaged a historically high 55% and bears 15% over the past four weeks, numbers indicative of market extremes. There are now fewer bears than at any time since 1987 and less than the lows at the 2000 and 2007 stock market peaks. Margin debt is at an all-time high. According to Vanguard, investors, as a group, have a 57% allocation to equities, an amount exceeded only twice in the last 20 years----the late 1990s and prior to 2007-2009. All of these numbers belie the belief by many that most investors are still too pessimistic.All in all, we believe that the market is facing significant headwinds, and that a major decline is not far off. In our view, economic growth and corporate earnings will be highly disappointing in the period ahead and investors will drop the pretense that the Fed can fix everything that ails the economy, particularly with the continued dysfunction in Washington and a restrictive fiscal policy. We believe that the risk of a major decline in the stock market outweighs the limited potential rewards from current levels.