Comstock Partners, Inc.December 17, 2009
Why We Remain Bearish
The stock market rally has now reached a point where it is forecasting a V-shaped recovery that is not likely to happen. The recent catalyst for all of this optimism is a bullish interpretation of current economic activity, some apparent stabilization in the housing market and various companies beating earnings estimates. Also not to be overlooked is the perceived strength of the Chinese economy that is affecting global growth and the upward move in some basic commodities. We think that all of these points are being exaggerated while the fear of missing the train leaving the station is resulting in a speculative surge that is likely to leave the majority disappointed.
The key factor to consider is that the so-called 'great recession' was caused by a credit crisis following an artificial boom and therefore bears more resemblance to the great depression following 1929 or Japan after 1989 than it does to the series of recessions experienced in the post World War ll period. After the collapse of the dot-com boom in 2000-to-2002 the Fed held interest rates at historically low levels for an extended period of time, and with the help of lax mortgage standards, complex securitized financial instruments and irresponsible ratings agencies, fostered a climate that resulted in a massive housing boom. Households were able to cash out their vastly increased home values through refinancing and home equity loans that allowed them to spend freely and reduce their savings even though wage growth was exceedingly sluggish. The consumer boom also led to the global buildup of capacity to satisfy the demand that was artificially induced by the free flow of credit that was mistaken for an abundance of liquidity by most economists and strategists.
Now the piper must be paid. Despite the deep recession into early Summer, the consumer is still being forced to adjust to a far lower level of spending. When that level is eventually reached the economy can again grow in a robust manner, but we are not near that point now. The massive fiscal and monetary stimulation put into effect over the last nine months has mitigated the credit crisis and prevented a global collapse, but has not avoided the need for the economy to readjust to a new set of circumstances. We are still faced with historically high debt levels, a low household savings rate and a subdued housing industry. Reducing debt and getting the savings rate up will take an extended period of time. Furthermore, as a result of reduced consumer spending there is also an excess of capacity that will impede capital expenditures as well. And let's not forget that foreign nations that have become dependent on the U.S. consumer for growth (read China) will have to find another way.
To briefly illustrate the nature of the adjustments ahead, consider the following. From 1955 to 1985 consumer spending accounted for between 61% and 64% of GDP. On September 30, this percentage had risen to 71%, an amount that is unsustainable given the artificiality of the boom that caused it. For the percentage to drop to a more traditional 65% of GDP, spending would have to decline by 7.8%. While this will not happen all at once, it will be a drag on consumer spending for some time to come.
Similar reasoning is applicable to household debt and savings. Household debt has averaged 57% of GDP over the last 55 years and was still at 64% as late as 1995. It has since soared to 98.6% (only slightly under its peak) giving a big boost to spending. Even if debt remains at a high level the absence of any further increase takes away a significant past source of growth.
The household savings rate mostly stayed in a range of between 7% and 11% of consumer disposable income in the decades prior to 1992, and steadily declined to around zero by 2008 before rising to a current 4.4% as consumers have started the process of reining in spending.. In the absence of rising home values and the virtual disappearance of mortgage equity withdrawals that, at its peak, accounted for an annualized 12% of consumer spending, the savings rate could easily climb back to a more traditional 9%. This would be yet another drag on spending.
In our view the economic recovery is on life support and is unsustainable. The progress seen to date is almost entirely dependent on temporary government programs that are due to be wound down. As that occurs the economy will be unable to expand on its own. Highly unfavorable conditions in three key areas---housing, commercial real estate and consumer spending---make it highly likely that economic growth will be extremely tepid or fall into another recession.
About 25% of all homes with mortgages are underwater with about half of these 20% under and more. Experience indicates that a large number of these mortgages will end up defaulting if they haven't already done so. Even now 14% of all homes with mortgages are in default or foreclosure. Home prices have climbed slightly over the past few months only as a result of the first-time homebuyers' tax credit and the fact that foreclosures have been temporarily backlogged as mortgage servicers have been determining who is eligible for modifications. When this process is soon completed those not qualifying will be thrown into foreclosure. In addition we are also facing another round of adjustable-rate mortgage resets that will result in even more defaults and foreclosures in the period ahead. When this happens home prices will resume their decline, putting even more mortgages under water. Let's not forget that increasing unemployment and lack of new hiring will result in more households that are unable to keep up their payments.
Commercial real estate (CRE) is another area that will subject financial institutions and the economy to further risk. CRE prices are already down 33% in 2009 and 45% from the peak with an estimated 55%-to-65% at prices lower than the amount of their mortgages. About $1.5 trillion of CRE mortgages mature over the next few years, and a substantial number of them will not qualify for refinancing unless already weakened financial intuitions take a big hit. A large number of the mortgage holders are small-to-medium sized community banks. This is another reason why these banks are so reluctant to make new loans to small business.
The third leg of the shaky economic stool is the subdued outlook for consumer spending. As we pointed out above, consumers are in the process of paring down debt and increasing their savings rate, a process that has barely started. The household debt/GDP ratio is still close to 100% compared to a 55-year median of 57%. While the household savings rate has increased to 4.4% from near zero, it generally averaged between 8% and 9% in the decades prior to 1992. While an increased savings rate benefits the economy in the long-term it tends to dampen consumer spending while the process is underway. Also hampering consumer spending is the fact that wages are down 5% from a year ago, unemployment is still rising, new hiring is still declining, net worth has plunged and consumer credit is tight. Consumer credit outstanding has dropped 4.3% over the past year, the most in at least 44 years. Household net worth has declined 12% year-over-year, the most in 57 years.
Another ominous development is the recent emergence of sovereign debt problems. The revelation of Dubai World's inability to pay its debts on time resulted in a one-day market drop that was soon easily dismissed as one-off event. After the initial blithe dismissal of the emergence of subprime mortgage problems, the world should have learned that such events never occur in a vacuum. After a world-wide debt binge based on the theory that assets can only rise in value, an unexpected severe decline in asset values has left debtors with too little cash flow to service their debts. It was therefore naïve to think that Dubai would be the only nation impacted, and, sure enough, the other shoes have started to fall. Fitch lowered their rating on Greece to BBB and S&P followed with a change in Spain's outlook to negative on its current AA+ rating. The firm had already downgraded Portuguese bonds a few days earlier. The distress in Greece, Portugal and Spain place the ECB in a tough position. The central bank has to do what is best for all 16 member nations as a whole, and when they tighten monetary policy the stresses on the weak members gets even worse. We would not be surprised to see other nations in debt trouble as well, both in the ECB and any where else on the globe
We believe that U.S. government and private debt levels will diverge over the next four or five years as the authorities attempt to use government debt to replace the private debt that is almost certain to decline substantially. U.S. total debt is presently just under $55 trillion, comprised of public (government) debt of about $15 trillion and private debt (U.S. corporations and individuals) of about $40 trillion. The similarities to Japan at its 1989 economic and market peak leads us to believe that we are close to the same road map that Japan was on starting at that time and continuing until today. With that said, we expect current U.S. government debt of $15 trillion to double to about $30 trillion and private debt to drop in half to about $20 trillion over the next 4-to-5 years.
The similarities between Japan's deleveraging since 1989 and the U.S. presently are eerie. Japan's total debt to GDP increased from 270% when their secular bear market started to just about 350% eight years later (1998) before declining to 110% presently. The U.S. increased their total debt-to-GDP from 275% of GDP when our secular bear market started in 2000 to 375% presently (10 years later), and we suspect a total debt decline similar to Japan's even though the Japanese government debt tripled during their deleveraging. The government debt relative to GDP was about 50% in both the U.S. and Japan when the secular bear market started. We also suspect that our government debt will grow substantially just like it did in Japan as the private debt collapses. The private debt in Japan decreased substantially from the peak seven years after the secular bear market started (dropping from 270% of GDP to 110% presently). If the U.S. were to follow Japan's deflationary road map, we would expect our government debt to increase from about $7 trillion (net government debt not including the debt used to fund Social Security) to about $21 trillion and the private debt to decrease from about $39 trillion to around $20 trillion. Also, the Japanese stock market doubled during the three years preceding their secular bear market in 1987, 1988, and 1989 while the U.S. market also doubled during the three years preceding the beginning of our secular bear market in 1997, 1998, and 1999.
All in all, the recession we have experienced is not a typical post-war decline, but the end of an era, and getting the economy back on its long-term growth trajectory will take an extended period of time. For the stock market this means a reduced level of corporate earnings and subdued price-to-earnings ratios. In this light we think that the big earnings increases forecast for 2010 and beyond are far too high. It is likely the recent rally has gone about as far as it can go without some proof that the economy can recover at a strong pace, and we think that this proof is not likely to come anytime soon.