Comstock Partners, Inc.September 06, 2017
WE ARE AS BEARISH AS WE HAVE EVER BEEN
And The Central Banks Have Not Even Begun To Shrink Their Balance Sheets
A reader of this commentary recently asked us if we were “throwing in the towel? The reader was, of course, referring to our long running bearish outlook for the U.S. stock market. To quote the great Bob Dylan, “The times they are a changin”…for the bulls, but not for us! We remain in the bearish camp as firmly as we have in the past. So below is a summary of our latest thoughts as to where things stand.
Let’s start with the root cause of what we believe will be among the most vicious bear markets in history, when it does occur. The major central banks of the free world have, since the Great Recession hit with full force as the Housing Bubble burst in the fall of 2008, expanded their balance sheets and printed money like no central bank has ever done before. The term for this is Quantitative Easing. The Fed, European Central Bank (ECB), Bank of Japan (BOJ), and Bank of England (BOE) have all purchased trillions of dollars of government debt and related securities. The ECB has also purchased large amounts of corporate debt, and the BOJ has upped the ante by even purchasing Japanese equity ETFs. They have yet to reduce their balance sheets by the equivalent of a single penny, and we believe they will find it very difficult, it not nearly impossible, to extricate themselves from the situation without highly negative effects on the markets. If Quantitative Easing was largely responsible for creating the bubble in financial assets we believe exists, it stands to reason that when they start doing the reverse the results could be very negative for the markets.
One of the major effects of Quantitative Easing is to drive interest rates lower than the free market would otherwise price them. In the case of Europe and Japan this has even resulted in negative interest rates. This is a first in the history of financial markets. Low and negative rates mainly punish savers. This has resulted in overpricing of stocks and bonds as investors from the developed countries, in particular, have chased returns.
Just how mispriced are the markets? Let’s start with U.S. equities. As of 8/31/17, the S&P 500 Reported Earnings were 23.8X Trailing Twelve Months (TTM). This is with the index less than 1% from its all-time high. By way of contrast, the Housing Bubble burst in 2008, but the market actually peaked in October of 2007. At the end of September 2007, the TTM P/E was 19.4X. Admittedly, the TTM P/E was higher before the DOT Com Bubble burst. The number was 29.4X and was skewed by the Tech sector. Though quarterly earnings peaked coincident with the highs, both earnings and prices continued to decline dramatically for the next two years. Other metrics, like price to sales, are by far the highest ever for the S&P 500 median company.
How about government bonds? Here is a recent cross section of ten year Government rates: United States 2.07%, Italy 2.02%, Spain 1.55%, United Kingdom 1.04%, France .67%, Germany .36%, and Japan .006%. Ask yourself. Does this make any sense? Could it exist in any world but a world where the central banks have run amok, and distorted financial asset relationships like never before. Clearly, at these prices, the bond markets are pricing in little, if any, growth. And apparently pricing in little, if any, default risk. Is Italy a better credit than the U.S.?
We are not the first to point out the dichotomy between the pricing of stocks versus bonds. In the US, 23.8X TTM earnings and a 2.07% ten year just doesn’t jive. Stocks are saying growth and bonds are saying no growth. We believe the bond market will be right for reasons we have stated in the past. The recent 3% print in Q2 GDP will, we believe, prove to be a blip. The long term population demographics, trends in numbers of both employed and those out of the workforce, low long term growth in productivity, and skilled immigration (or lack thereof) will all prove to be a long term inhibitor to growth.
As far as President Trump’s ability to get his agenda through congress it is not at all clear that he will be successful. And even if he is, in our view, it is already priced in. There used to be a saying that “politics stops at the waterline”. This referred to the fact that even though we Americans have our differences, we are still Americans and when a foreign threat arises, we are united as one and all politics cease. Today that old saying seems to have morphed into “politics stops at the center of the aisle”. Anyone that thought that acrimony had peaked at the end of the Obama administration, (naively) thought wrong! Never before have we witnessed such political division that seems to be mainly for the sake of division. So we’ll see where that all goes, but it doesn’t appear to be a good development given we are hovering near all-time highs in the major indexes.
We thank our readers for their loyalty and attention and assure them that the towel still rests in the corner. We’ve wiped some sweat from our brow, but are standing and waiting for the bell and the next round, when the central banks reverse what they have been doing for the past few years (8 years for the Fed). And when they reverse, it could be very detrimental for stocks.