Your Economy (No Politics)

[Bullwinkle]

It's All About Greed and Fear
Comstock Partners, Inc.
Wednesday, July 12, 2006


This comment is a little longer than most and is posted one day early due to our travel schedule.

This comment deals with the herd like instincts of public investors in the stock market, as well as almost any form of investment that is dictated by the strong emotions of greed and fear. Although culture, technology and financial instruments undergo great change over time, human nature remains the same and emotional highs and lows in financial markets are a fact of life that never changes.

A modern example is the early 1980s financing and marketing of oil and gas tax shelters from the drilling areas of Texas and the Gulf of Mexico to Wall Street where there seemed to be unlimited demand for anything to do with oil and gas. This demand coincided with the peak in oil and gas prices in the early 1980s leading to heavy losses, bankruptcies, a crash in Texas home prices, and the necessity to bail out every sizeable independent bank in the state. Another example of public “irrational exuberance” was the length of lines of people around the blocks of downtown Manhattan seeking to buy gold and gold coins, just as the price of gold was peaking in 1980 at just over $860 an ounce. Time after time, it is apparent that the public always buys heavily what it most recently missed, and subsequently liquidates with major losses.

We will show you, in this report, the enormous greed that drove the public into massive buying of stocks and equity mutual funds right at the top in 2000. This was right after the NASDAQ achieved gains of 40%, 23%, 22%, 40%, and 85% in the respective years 1995, 1996, 1997, 1998, and 1999. These record purchases of NASDAQ stocks and equity mutual funds in 2000 (especially the first quarter of 2000) were followed by negative returns of the NASDAQ of -37%,-21%, and -31.5% in the respective years of 2000, 2001, and 2002.

As most of our regular readers know, we believe that the late 1990s was the greatest financial mania of all time and made the”roaring” 1920s look like a day at the beach in comparison. Remember when Ariba had a market capitalization of $47 billion and CMGI Inc., and Internet Capital Group each had a market capitalization of 150% of DuPont, and each had a market cap of 200% of Dow Chemical? We could go on with many more examples of this, but suffice it to say that it was an unbelievable mania that drove the NASDAQ PE to 245 times earnings. This was 10 times the average PE over the past 20 years (and this included the years of the mania). The mania also drove the PE of the S&P 500 to double the multiples of the prior peak periods such as 1929, 1937, 1946, 1972, and 1987. The PE rose to over 40 while the past market peaks averaged slightly over 20. These prior market peak periods were typically followed by market troughs where the valuation level would decline to approximately 10 times earnings or less. After the financial mania of the late 1990s the market trough of October 2002 coincided with a PE multiple still above 20 and now (after an unsustainable explosion of earnings) we are still trading at the 80 year average of a 16 PE. And remember this includes the period of the late 1990s and early in the year of 2000 which were outrageously high.

It is our contention that the PE ratio will return to the past bear market trough levels of 10 times earnings or less. This means the S&P 500 would trade at 800 or less, if, and only if, the consensus earnings estimates of approximately $80 for 2006 and 2007 are realized. We happen to think there is a high probability of a recession, and if we are correct the $80 estimates will be too optimistic.

We also believe that the market needs a catalyst to drive the S&P 500 from the current levels of 1270 to under 800. We think the catalyst will probably be a recession caused by the Fed tightening and the peaking of the housing market. Remember, housing is the glue that is holding the virtuous worldwide investment cycle together. Housing price increases generate the wealth effect which allows the consumer to buy foreign goods. The dollars are then recycled back into the US by foreign central banks purchases of treasury securities. It could also be the sopping up of the liquidity provided during the worldwide bear market of 2000-2002.

Either way, the public’s liquidation of equities as well as equity mutual funds (EMF) will exacerbate the decline. The reason it is so important to monitor equity mutual fund cash flows is due to the tremendous accumulation of domestic equity mutual funds at the top as we discussed previously. The public dumped just over $140 billion into EMFs in the first quarter of 2000 even though the market peaked during that quarter. The public then averaged down by buying a record $300 billion during the full calendar year. To put this into perspective, prior to 1990 there was never a year where there were more than $20 billion of net purchases of EMFs.

We did have some public liquidation after the stock market broke down in 2000-2002, but the liquidation was not close to the prior liquidations in past bear markets that drove the valuation levels down to around 10 and below as we discussed previously. This provided a significant buying opportunity for any student of financial history. We strongly felt that we would get one of the buying opportunities of a lifetime after the financial mania, and it is hard for us to believe that the buying opportunity came in October of 2002 when the PE at that trough was still in the mid 20s.

The liquidations after the 1973-74 bear market continued for almost a decade and worked out to about 8-10% a year of the total assets in EMFs at the time. The 1987 crash precipitated a liquidation of $25 billion over a period of 15 months on $186 billion of total assets in EMFs. That works out to 13.5% of the total assets at the time. If we were to experience a similar capitulation presently, the net liquidations would be around $400-$550 billion a year rather that the $90-$98 billion of liquidations we had over a 5 month period of time in 2002, and the $26 billion of liquidations over the calendar year 2002. Notice also that these liquidations only drove the valuation level to the mid 20s PE vs. the normal bear market trough of less than 10.

However, instead of continuing the liquidations of 2002 and achieving a final “wash out”, the stock market rallied and the capitulation was never accomplished. Instead, the public has been attracted back into equities and EMFs over the past 3 years and now we have more money in both domestic and foreign mutual funds than we had at the prior peak in 2000. We now have $4.3 trillion in domestic EMFs versus $4.0 trillion at the peak in 2000, and $5.5 trillion in domestic and foreign EMFs versus $4.5 trillion in 2000. It seems like they just never learn! If we actually do start a bear market either due to a recession or strictly reverting to the mean of past bear market valuations, the public’s liquidation will substantially exacerbate the decline.

In summary, the secular bear market we believe we are in presently will not end until the public has the typical bear market capitulation and liquidates on the order of $400-$550 billion of EMFs. That is the type of liquidation that could drive the S&P 500 to 800 or maybe much less and thereby provide a buying opportunity of a lifetime.

• NDR MUTUAL FUND NET CASH FLOWS
• CASH FLOWS OF ALL MUTUAL FUNDS (INCLUDING FOREIGN)
• CASH FLOWS OF DOMESTIC MUTUAL FUNDS

http://www.comstockfunds.com/index.cfm/act/newsletter.cfm/CFID/3100225/CFTOKEN/15616716/category/Mar...