Why 1994-1995 is not Relevant Today
Comstock Partners, Inc.
Thursday, December 1, 2005
In our view the current rally is based on fear of missing a widely expected year-end market surge and the anticipation of an end to the Fed interest rate hikes after another couple of 25 basis point rises. That is why the market has recently gone down on positive economic news and up on more negative news. We have reached the point, therefore, where good economic news is now perceived as bad news, since it means higher interest rates, while bad news is good news since it raises the likelihood of an earlier end to Fed tightening. However, as discussed below, we don’t think the end of rate rises will be positive.
For a number of reasons, we believe that the market surge is not sustainable. First, the year-end rally has been so widely publicized and expected, that it is highly likely it almost over, and that what we’ve seen is what we get. Second, there are already clear indications that the underlying foundation of the economy is now weakening and will soften further in the months ahead. Although this will lead to an end of the Fed interest rate hikes, the softer economy or outright recession that follows has not been discounted by the market. Third, the market remains highly overvalued and sentiment is at high levels.
In our view the economy is already showing signs of softening. Housing is beginning to weaken. MBA mortgage applications are declining and mortgage refinancing is plunging. The inventory of unsold homes is the highest 19 years. The housing affordability index is at its lowest point in 14 years. While new home sales were reported to be up by 13% last month, the number was so out of line with other data that even the chief economist of the National Home Builders Association called it “bizarre”. Since sales of homes at huge profits combined with cash-out refinancing has provided the funds for consumer spending in the face of negative savings rates, an end to the housing boom is highly negative for ongoing spending.
Despite the publicity to the contrary, consumer spending has already been sagging. Real consumer spending was down 0.9% in August, down 0.4% in September, and, as reported today, up only 0.1% in October. Given this trajectory, spending increases will have to average almost 0.5% in November and December just to get to zero growth for the fourth quarter.
A great many observers are comparing this period to the end of 1994 when the Fed was similarly approaching the end of a series of rate increases. They like to point out that stocks then broke out into a long bull market that ended at far higher levels in early 2000. There are, however, some important differences. Towards the end of 1994 investors were exceedingly pessimistic about the market, while they are quite optimistic today despite numerous problems. In late 1994 the Investors Intelligence Survey showed only 32% bullish and 50 % bearish, compared to today’s 54% bullish and 23% bearish. In addition the cash-to-asset ratio was about 8% then compared to only 3.9% now. The household savings rate was 8% at that time, and negative now. Both the trade deficit and household debt were small fractions of what they are today.
In terms of valuation the S&P 500 is selling at 19 times earnings now compared to 15 times then. From that point the market soared to 37 times trend-line earnings by early 2000. That price-earnings ratio capped the stock market bubble, and was 76% higher than the top of any market P/E for over one hundred years. In 1994 we were in the midst of a secular bull market, while now we are in a secular bear market with this year’s high still a substantial 20% lower than the level reached five and a half years ago. Since the Fed began operations in 1913 the vast majority of tightening periods have led to recessions and bear markets. The bear markets did not generally end until the Fed eased two or more times---and for good reason. When the Fed stopped tightening the market usually reacted negatively to increasingly disappointing news on the economy and corporate earnings. The experience to the contrary in 1994-1995 was the exception rather than the rule. We continue to believe that the monetary, economic and sentiment indicators point to great risk in the market at this juncture.
© 2005 Comstock Partners, Inc.
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