A High-Risk Market
by Comstock Partners, Inc.
Thursday, October 6, 2005
In our view the stock market remains in a precarious position and appears set to start the next downleg in the secular bear trend that began in early 2000. The consumer is in fragile shape at a time when the Fed seems determined to keep hiking rates, energy prices are soaring, valuations are excessive and the economy is wrestling with the numerous problems brought on by Katrina and Rita.
Even before the twin hurricanes the consumer savings rate had turned negative, household debt was at record highs and home owners were using soaring home prices as huge ATM machines yielding hundreds of billions of dollars in cash. With housing prices starting to soften, energy prices still high and real wages under pressure, consumers’ ability to spend seems severely restricted in the period ahead. These trends have been further exacerbated by the two hurricanes that have created negative domino effects throughout the economy. So far consumers have felt the impact of higher gasoline prices, but with the coming of cold weather they will be facing heating costs that are estimated to be up by about 70% from last winter. At the same time minimum monthly payments on credit cards are rising while interest rates on the cards are also going up. All of these factors have resulted in a sharp drop in consumer confidence. The continuing problems in Iraq and Iran as well as the decline in the President’s approval ratings have also added to the general malaise. History strongly indicates that such low approval ratings and bull markets are usually not compatible.
Industry is also beginning to feel the effect of high energy prices as a large number of companies have indicated that their costs are rising at an increasing rate. These will either be passed along in the form of higher prices or absorbed as a hit to earnings. The potential inflationary threat is being used by Greenspan and other Fed governors as an additional reason to keep hiking the funds rate, although we believe that the Chairman’s recent speeches and congressional testimony indicates a deep concern about the bubbling housing situation. We note again that a period of tightening monetary policy and a narrowing yield curve has almost always resulted in a sharp decline in economic growth or an outright recession. While this time could prove to be an exception, we see no reason to defy such overwhelming odds, particularly in light of all the other existing problems.
The bulls counter by stating that all of the above problems are well known and have, therefore, been discounted by the market. However, mere acknowledgment that a problem exists does not mean that it has been discounted. Discounting a potentially market-moving event means that the market has either undergone a major decline (bear market) in anticipation or recognition of negative events or a major advance (bull market) in expectation of positive events. Although the market began a secular decline in early 2000, it bottomed in October 2002, and started a counter-trend bull market that made a cyclical high in late July, and was close to that top only three weeks ago. It’s easy to see, therefore, that there has been no significant decline so far that has discounted the dire outlook we see ahead.
In fact, the reason the market has held up so well until the last few days is that the majority see the current problems as temporary events that will clear up shortly with a strong economy and ample earnings to follow. It is that view that is actually being discounted by the market. While the bulls are certainly entitled to that opinion, it is circular reasoning to turn around and then claim that the bad news is being discounted. Simply put, if the majority believes that the bad news is discounted, you can be sure that it isn’t. In our view, there are few if any catalysts to propel the market ahead, while the risks are heavily on the downside.
© 2005 Comstock Partners, Inc.
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