Why We Remain Bearish: A Summary
Market Views of Comstock Partners, Inc.
Thursday, June 2, 2005
In our view we are in the final phase of the cyclical bull market that started in October 2002. This has taken place within a secular bear that peaked in March 2000 after rising for 18 years. Even now the comprehensive S&P 500 remains 22% below that top while the Nasdaq Composite is still 59% off its historical high. The S&P 500 is now at about the same level reached in 1998, and the current cycle is highly likely to top at a point far below the level achieved five years earlier.
The bull market was based on an economic recovery spurred by two major tax cuts and massive ease by the Fed that used soaring asset values, primarily in residential real estate, to support consumer cash flow in the absence of normal growth in employment and wage income that usually provides the support for economic expansion. The result is record consumer debt, historically low consumer savings rates, a massive trade deficit and big federal budget deficits. The record stimulative policy avoided the immediate negative consequences of a bursting financial and economic bubble, but only at the cost of exacerbating these structural imbalances that will prove difficult to resolve without a major crisis. The stimulative effects have now faded, and, instead, we are faced with a tightening Fed monetary policy and soaring energy prices that are likely to work against economic growth in the period ahead.
Our bearish case is relatively simple. Valuations are in the high end of the historical range. The major tax decreases that helped jump-start the economy are now in the past. The Fed is continuing to raise rates. Cash-outs from mortgage refinancings are about 75% below the peak. Consumers have drawn down their savings rate from the historical 7-to-9% range to a point now approaching zero. Consumer debt relative to GDP is at record levels. Sentiment on the market is still high as evidenced by the Investors’ Intelligence bull-bear survey, the relatively high percentage of institutional equity holdings, the proliferation of hedge funds and the low level of equity mutual fund cash as a percent of assets. In addition, investors never capitulated during the 2000-2002 bear market. To top it off, the economy is already showing significant signs of deteriorating. All of these factors are symptomatic of a market that has little reason to rise and a lot of reasons to fall.
Despite the positive hype, it appears probable that the economy is headed for a significant slowdown or recession that has not been discounted by the market. We draw these conclusions from some significant indicators that have shown good lead times in forecasting past economic cycles. The PMI Index, which has been heading down for a number of months, leads industrial production by about five months. In turn, industrial production leads manufacturing employment by four months. Furthermore rising energy prices tend to lead the economy by about a year, meaning that the increases we have already witnessed are baked in the cake even if oil prices should decline from here.
We also note that since the start of the Federal Reserve System in 1913 periods of tight money have almost always been followed by an economic slowdown or recession—most often a recession. The year-over-year decline in money growth as measured by money to zero maturity (MZM) has now dropped to a point that has led to slowdowns or recessions over the past 40 years. Another study reveals a significant high correlation between the growth in real M2 and final domestic sales. This is recognized by the Conference Board, which gives this the second highest weighting in its calculation of the leading indicators. Real M2 has declined from a growth rate of 4.4% in the first quarter of 2004 to only 0.6% in the first quarter of this year. A similar study indicates a strong correlation between a narrowing yield spread (the 10-year bond to the fed funds rate) and a subsequent slowdown or decrease in final sales. The spread was 359 points in the second quarter of 2004, 183 in the first quarter of this 2005, and 118 now. In fact, the Conference Board gives this indicator the top weighting of its 10 leading indicators.
The leading indicator index as a whole has now declined year-over-year, and over the last 40 years such an occurrence has always led to a slowdown or recession. Moreover, these U.S. indicators have been supported by persistent ongoing weakness in the global economy. The OECD leading indicator has also been sharply lower while the Japanese economy has again shown signs of deterioration despite having shown no sustainable recovery during a period now in its 17th year. Recently, various leading indicators in numerous nations world-wide have been showing significant slowdowns. Although the majority of economists insist that both the U.S. and global economies are in fine shape, we give far greater weight to the cited indicators, which have a far better record in forecasting changes in economic direction.
A number of observers maintain that the factors we cite are merely a reflection of the historical record that may not be applicable at this juncture. While we respect that opinion, we see no reason to assume that things are different this time. As everyone probably knows by now, the “this time is different” refrain has been prevalent at every major peak in every publicly-traded instrument throughout the globe. This is true whether it applies to stocks, currencies, gold, silver, copper, or soybeans. Human nature never changes, and, at market extremes, emotions overcome rationality with greed taking over at tops and fear at bottoms. In our view there is nothing in the current economic and financial situation that is different enough to override normal cyclical and secular patterns. The industrial revolution began to take off about 200 years ago, and since that time we have seen the development of steamships, railroads, electricity, telegraph, telephone, automobiles, airplanes, air conditioning, plastics, and semiconductors as well as medical advances resulting in vast increases in human longevity. Current developments in computer power, telecommunications, genetics and biotechnology, while astounding in many ways, are a continuation of past developments rather than an entirely new departure. It seems to us that if things are really different this time, the burden of proof is on those espousing that view, and we believe that they have not come close to making a convincing case.
In sum, given the continuing high valuations, the uncorrected economic and financial structural imbalances, and the lack of further fiscal and monetary ease, we believe that the market is in a secular decline that will resume shortly
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