Watch Out Below
by Comstock Partners, Inc.
Thursday, Novemer 3, 2005
With the entire arsenal of the federal government and investment industry geared toward moving the market up, investors must sift through the jumble of static and the overload of information in order decide what’s really important at any given juncture. In our view the key factors to watch at this point are monetary policy, the economy, valuation, and the action of the market itself.
It is clear to anybody on the planet that monetary policy is in a tightening mode. The Fed has raised the funds rate from 1% to 4% in a series of 12 moves over the last 17 months, and it is reasonably certain to go to 4.5% over the next two meetings. Since the beginning of the Fed in 1913 the vast majority of tightening periods led to bear markets and recessions, with soft landings few and far between. The Fed’s overriding concern about potential inflation resulting from the attempted pass-through of soaring energy costs to other goods and services virtually ensures continued rate hikes until the central bankers are convinced that the attempted price increases are failing to take hold. It can only do this by dampening general demand for goods and services—and this includes housing too.
As we have emphasized numerous times the economic expansion is exceedingly fragile as it has been based on raising cash from soaring asset values (mainly home prices) rather than on rising wages and salaries. Households have maintained their spending patterns only by sharply reducing their savings rate and taking on record debt. Freddie Mac estimates that cash-out refinancing has raised $214 billion in 2005 alone following hundreds of billions in the last few years. With soaring gasoline and heating costs also added to the deadly mix, it seems inevitable that consumers will have to slow down their spending in the months ahead. Already, real consumer spending has declined in both August and September. In addition real wages were down 2.3% in the third quarter and, even with benefits included, were down 1.5%.
At the same time the market is still significantly overvalued, although not by as much as in early 2000. We know you’ve seen the pundits on TV and in the press loudly exclaiming that the market is undervalued at only 14 times earnings and you wonder how this can be. As concisely as possible, here is the way we see it. Over a long period of time the S&P 500, on average, has sold at 15.9 times trailing reported (GAAP) earnings. Since estimated reported earnings were $67 as of September 30, 2005, the index at today’s close of 1220 is 18.2 times earnings. That’s an overvaluation of 14.5%--and keep in mind that most bear markets have bottomed at between 8 and 12 times earnings, not at the average. In order to come up with the idea that stocks are only selling at a P/E of only 14, the pundits go out to 2006, and, in addition, use questionable operating earnings, which they estimate at $86.34. What they ignore, however, is that the average historical P/E on forward-looking operating earnings is only 11, meaning that even on their terms the market is overvalued by 27%. We also think it highly likely that even that operating earnings number will fall far short of estimates.
As for the market itself, the fact that the major averages still remain far below the peaks made over five years ago is a strong indication that we are in a secular (long-term) bear market. After bottoming in October 2002, the S&P 500 rallied strongly to 1117 by the start of this year, but now has been in a trading range for over 10 months. In our view the eventual breakout will be to the downside, and the damage is likely to be severe.
© 2005 Comstock Partners, Inc.
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