Why We Remain Bearish Comstock Partners, Inc. Thursday, June 1, 2006
Yesterday’s release of the Fed’s minutes from the May 10 meeting further confirms our view that the economy and markets are caught in the crosscurrents between potential inflation, a softening economy and a weaker dollar, exacerbated by domestic and global structural financial and economic imbalances. Some observers attribute Machiavellian motives to the Fed’s professed concern with inflation, stating that the FOMC is merely talking tough to prove their anti-inflationary credentials so that they can pause at the June meeting. Others fear that the Fed won’t pause, and that any additional rate hikes will throw the economy into recession. In our view the central bankers just don’t know what they are going to do, and with good reason. The Fed is caught in a serious dilemma, and no matter what they do from now on the outcome for the economy and stock market is likely to be highly negative. The comment that follows is lengthier than usual as it reviews all of the themes we have been writing about in recent months.
From both a fundamental and technical view the stock market appears to be in transition from bull to bear as it rapidly approaches a no-win situation. Fundamentally the market is being pulled by the fear of inflation on the one hand and the fear of recession on the other. We are seeing soaring prices in energy, industrial commodities and gold at a time when the dollar is weakening and the core PCE deflator is pushing against the upper limits of the Fed’s tolerance. Anecdotally, a number of companies have announced that they are passing through these price increases and many others have indicated that they are close to doing so.
At the same time some leading sectors of the economy are softening, and it may already be too late to stave off a recession. By far the most important of these sectors is housing, both because of its historical record of leading the economy and the hundreds of billions of dollars in mortgage equity withdrawals that have powered consumer spending. Existing home sales fell 2% in April and are down 5.7% from a year ago. Monthly supply of homes for sale is the highest since January 1998. Although new home sales were up in April, they are down 11% since October, and the 5.8 months of supply is near a ten-year high. The NAHB index, a measure of builder optimism, is at its lowest level since June 1995. Leading home builder Ryland said its second quarter sales were running 35% below last year and sharply cut its earnings estimate for the quarter and full year. Another big builder, Toll Bros., also slashed its sales and earnings estimates. Other leading home builders have issued similar announcements over the past two months. Housing is likely to weaken even further due to eroding affordability, rising ARM rates, the crackdown on creative financing and the increasing caution of investment buyers.
A slowdown or actual decline in housing prices is likely to have a severe impact on the economy. In the absence of vigorous increases in wage and salary income during the current economic expansion, consumers have used the soaring values of houses to maintain their rate of spending and drastically lower their savings rate. The values have been turned into cash through home turnover, mortgage refinancing cash-outs, and home equity loans. A recent Federal Reserve staff study--significantly co-authored by Greenspan himself—estimated that “discretionary extraction of home equity accounts for about four-fifths of the rise in home equity mortgage debt.”. They further estimated that about 1/4 to 1/3 of the so-called mortgage equity withdrawals (MEW) directly financed personal consumption expenditures. Other estimates run as high as 50 or 60%.
The Greenspan study went on to say that if mortgage rates rise and loan affordability drops further, MEW would decline and the subsequent fall in consumer spending would lead to a drop in consumer goods imports as well as the intermediate goods associated with them. He estimated that MEW was about $600 billion in 2004, an amount equal to 7% of GDP, and that the accumulative MEW accounted for the entire decline in the household savings rate since 1995. Other studies indicate that similar amounts were raised in 2005 as well.
It is therefore easy to see that a drop in home prices would have highly negative consequences for the global economy as well. For the last few years the global economy has been held together by a delicate balance in which soaring U.S. home prices supported domestic consumer spending that pulled in imports from abroad resulting in rapidly rising trade deficits for the U.S. and big trade surpluses for the rest of the world, particularly China and Japan. As is by now well known, most of the huge store of dollars accumulated by the nations running the surplus has been constantly recycled into the U.S. largely through the purchase of Treasury securities, resulting in the so-called Greenspan “conundrum” of unexpectedly low long-term rates. These relatively low long rates were reflected in the low mortgage rates that goosed housing prices and allowed for the positive feedback loop in which both the U.S. and its trade partners benefited.
The real issue that separates the bulls from the bears at this point is this—how long can the positive feedback loop last? The bulls feel that this relationship is so advantageous to both sides that no one will want to see it end, and that the world, therefore, has found a new economic balance that will go on indefinitely. We disagree. The housing boom is clearly ending, and this is the glue that holds the balance together. Without continually rising U.S. home prices consumer spending declines, the savings rate climbs, U.S. imports drop, foreign economies soften and what was a positive feedback loop suddenly reverses and becomes a negative loop. In other words, without the U.S. housing market to support it, the fragile balance holding the global economy together unravels with disappointing results for the economy, corporate earnings and the stock market. Judging from the tone of his research study, speeches and testimony, Greenspan seems to understand the gravity of the problem, but, has always concluded that the imbalances can be resolved gradually over time. In any event, the baton has now been to Ben Bernanke, and the market is beginning to realize the extent of his serious dilemma. In the meantime we believe that the risks to the stock market are far higher than the complacent majority recognizes.
Recently, the market has been rallying on any sign of economic weakness and declining on economic strength, as investors are playing for a rally once the Fed stops hiking interest rates. Both Wall Street and the media are giving the impression that this is normal by constantly referring to the major market rise after the Fed stopped tightening in early 1995. What they are ignoring, however, is that the 1995 experience is the exception rather than the rule.
Simply put, there have been 12 periods in the last 53 years where the Fed has engaged in a series of rate hikes. In 10 of these instances the S&P 500 subsequently declined AFTER the final rate increase, with an average drop of 22% to the eventual bottom. On average the market bottom occurred 10 months after the end of tightening. Importantly, an economic recession followed in 9 of the 12 cases. On average, the peak of economic cycle took place 4 months after the last rate increase, although in two instances the peak actually occurred first, meaning that the last tightening was implemented after the recession started, but before the Fed was even aware of it.
Since the history is so clear that the probabilities point to a significant market decline and recession after the last Fed rate hike, it seems to us that investors are battling against overwhelming odds in assuming that this time will be different. They are rooting for economic weakness because they know that this will induce the central bankers to stop raising rates soon. The problem, though, is that the lead time between rising rates and their impact on the economy is fairly long, and that once the Fed sees an actual softening in the economy it is usually too late to prevent the most recent rate hikes from taking the economy from mere softness to recession.
Investors therefore end up wanting to see the economy weaken, but at the same time they stick with their forecasts of robust economic growth and strong earnings gains. They are then able to remain bullish on the grounds that the Fed will stop tightening soon while the economy will stay strong with earnings showing good gains. In our view these two results are inherently contradictory, as history strongly indicates.
In the current situation we think a bear market and recession is even more likely than in prior periods of Fed tightening because of high market valuations, soaring energy prices, higher industrial commodity prices, the record trade deficit, the huge household debt-to-GDP ratio, and the potential unwinding of the housing boom. When we also consider that the consensus of economists has never forecast a single recession and the vast majority of investors have never seen a bear market coming, why take their current rosy predictions at face value when indicators with a far better record of forecasting are saying the opposite? Although anything can happen in the market, we prefer going with the stronger probability.
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