Secular Bear Market Continues
by Comstock Partners, Inc.
Thursday, October 20, 2005
As we stated in our October 13 comment, we believe the risk to the bears is an upside breakout above the 1240-1245 zone with the rewards down to about 600-700 on the S&P 500. We came up with these numbers knowing that the length and magnitude of the counter trend rally in the ongoing secular bear market should not significantly exceed the level that the index reached three times this year. We also believe the coming decline should take the S&P 500 down to about 10 times or less 12 months trailing reported earnings. Consensus reported earnings are expected to come in around the $70 area this year and S&P estimates earnings of about $70 in 2006, although most estimates are higher.
We questioned the ability of earnings to match the $70 in 2006 in the September 22nd comment, stating that “The reasons that we feel that this strong growth of earnings will not continue are fourfold. One, we don’t believe the profit margins that have reached their historical peaks will be able to sustain those levels. You can see from the attached chart that once they reach these historic peaks they revert back to the mean and below. You can also see that the profit margins were at these same extremes in 2000. Secondly, the consumer has leveraged their consumption relative to wealth and income to extreme levels which cannot be sustained. Thirdly, the housing bubble which has supported consumption in the past few years is close to bursting and will leave in its wake a reverse wealth effect and a severe reduction in the ability to use one’s home as an ATM machine. The fact that the consumer savings rate is negative combined with no appreciating asset to leverage against doesn’t bode well for continued consumption. The fourth reason is the monetary and fiscal stimuli which were in force during most of the strong earnings growth are no longer helping. The monetary stimulus has been reversed for over a year as evidenced by this week’s 11th rate rise over the past 15 months.” We also stated that the cost of energy is a drag on non-energy consumer spending and that corporations would have to try to pass on the increased cost to the consumer or suffer from reduced profit margins.
Mr. Greenspan emphasized this very point in a speech in Tokyo this week when he stated, “the recent surge in energy prices will undoubtedly be a drag on global expansion”. These comments, combined with the latest CPI and PPI reports, did not help generate much confidence by investors in the stock market. In fact, the CPI rose by 1.2 % in September, the biggest one-month increase in a quarter-century as gasoline prices at the pump climbed by a record 17.9%. The Labor Department reported that wholesale prices jumped 1.9% in September, led by surging prices for gasoline, natural gas, and home heating oil. We look at these increases in energy as a tax on the consumer that will, in the end, be more deflationary than inflationary, as debt ridden households will find it more difficult to handle their record debts, especially as interest rates continue rising. As ISI points out in a comment this week, “Both wages and benefits and under downward pressure at the same time energy costs have exploded”.
Another indicator that came out today and supports our contention that the S&P 500 earnings will not match this year’s estimate of $70 is the index of leading economic indicators, which dropped 0.7% in September and has now declined over the past 3 months. This widely watched measure of future economic activity could be signaling a major slow down next year, if not an outright recession.
All of these negative factors feeding on one another leads us to believe that the secular bear market is resuming and the stock market could be turning very “ugly” over the next year to 18 months.
© 2005 Comstock Partners, Inc.
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