Comstock Partners, Inc.March 27, 2008
"How We Got Into This Mess!"
This Special Report will deal with the possibility that the market move of the past five years was not the bull market that everyone else believes, but instead a very strong counter-trend move in a secular bear market. As everyone now knows, there was a truly unbelievable financial mania in the late 1990s that produced a severe bear market and a mild recession. This was followed by 13 rate reductions by the Fed that produced an unprecedented rise of the housing market and doubling of the stock market over the following five years. The amazing part of this rise of these two markets was that they both started their run in 2002 from levels that were previously considered extremely expensive and only seen at tops-- not bottoms.
The stock market and economy experienced the greatest financial mania of all time in the late 1990s. Companies were going public without earnings and sometimes without revenues and doubling or tripling the same day as the IPO. It seemed like almost any company that had a dot com at the end of their name climbed to levels that stock market students will find astonishing and will wonder how something so absurd could have occurred for such a long period of time. Stock market analysts were competing with each other as to what their targets were on any company that had anything to do with the internet. An obscure analyst came on CNBC and became instantly famous when he predicted that Amazon would rise to $400 a share from the then-current price of about $150. As a result of this interview, he was hired by Merrill Lynch where he continued to make similar outrageous predictions. However, many of these outrageous predictions came to pass (including Amazon) because the market environment was so insane. Eventually almost all of his stock recommendations, as well as most speculative stocks collapsed in the bear market of 2000-2002.
There were many events during the late 1990s financial mania that could have severely broken the market. We had a currency crisis in Asia when the Thailand Bat crashed and took out a couple of hedge funds with it. We had a worldwide panic when Alan Greenspan warned about the "irrational exuberance" of investors near the end of 1996. Then there was Long Term Capital Management, a hedge fund managed by a bunch of PhDs and Nobel Prize winners, that blew up in 1998. All of these events caused significant declines in the market, but all of those declines proved to be great buying opportunities as the market continued up through the end of the twentieth century.
The most useful metric for stock market valuation, the P/E ratio for S&P 500 reported trailing earnings, traded in a range of around 10 to 20 for almost 100 years. It typically rose to around 20 before peaking at the end of bull markets and declined to around 10 or lower at the trough of bear markets. Sometimes the market rose to a little higher than 20 at peaks and sometimes the bear markets took the valuations to a little under 10, but for the sake of simplicity, think in terms of around 10 to 20 as the history of peak and trough valuations. During the financial mania of the late 1990s the PE ratio of the S&P 500 rose to around 40 or double the typical peak of 20. After what was discussed in the previous paragraph you can see that with all of the insanity going on in the markets this shouldn't be a surprise.
The market started down slowly in 2000 -- it was mainly the dot com bubble stocks that started down at the beginning of the year. The rest of the stocks started catching up with the dot com decline by September of 2000. The market continued to decline through 2001, and most of 2002 taking the S&P 500 down about 50% and the NASDAQ down about 80%. The S&P declined from about 1525 to just under 800 while the NASDAQ declined from about 5000 to 1100. The Dow Jones Industrials declined from 11,900 to about 7200 or about 40%. These declines would be, under normal circumstances, enough to believe that the bear market corrected the excesses of the late 1990s and that we should be off and running with a new bull market.
There were three things that we thought had to take place before the market made a valid significant bottom. First, the market trough of 775 for the S&P 500 was still at 26 times earnings (or higher than every market peak in stock market history until the bubble of the late 1990s). We would have expected the market to trade closer to 10 times earnings or less since that is where most market troughs traded at historically. Since then the PE has declined to around 20 times earnings today (typical at market peaks not troughs) even with the market doubling due to the earnings increases.
Second, the debt build up during the late 1990s was never liquidated as you would have expected in a recession. Instead, we experienced one of the mildest recessions in history with minimal effect on the public and no debt liquidation at all.
Third, the bear market of early 2000 to October of 2002 never experienced the public capitulation that we expected and discussed in our comments all through the year 2002. The liquidation of equity mutual funds was less than 1% of total equity mutual funds after the largest inflow of money into these same equity mutual funds in the first 2 quarters of 2000, coinciding with the peak in the market. The typical liquidations of equity mutual funds was 8% & 14% in the market breaks of 1987 and 1973-74 respectively. It was hard to believe the stock market was on its way to starting a new bull trend with this relatively minor public capitulation after the greatest financial mania of all time.
VALUATION LEVELS WERE NOT ONLY HIGH FOR STOCKS, BUT REAL ESTATE VALUATIONS WERE EVEN MORE EXTREME
Again, the S&P 500 did rise from 775 in October 2002 to 1575 in October 2007 while the Dow Jones Industrials rose from 7200 to 14,200. The NASDAQ rose from 1100 to 2900 for a percentage gain of 170%, but remained well below the 5000 level reached in early 2000. The main reason for this increase in stock prices before the typical wash out and capitulation that is typically experienced before a rise like this was the impact of the Fed. Alan Greenspan's rate reductions of both the Fed Funds rate and the Discount Rate from 6% to 1% not only propelled the stock market to just about double, but also propelled the value of residential homes in many areas of the country to also double. We did understand that the Fed would attempt to start a new bull market in stocks and real estate with these reductions, but found it hard to believe that these new bubbles could occur from the elevated valuation levels of both stocks and real estate. And we were sure that if the markets did rise from these levels that it could only be because of government intervention to stimulate the economy and stock market.
We have already mentioned that the PE of the S&P 500 at the October 2002 bottom was actually 20% higher than the PE typically seen at peaks. But that wasn't the main asset category that was spurred upwards by the rate reductions. The main asset category was real estate that was trading at the highest levels in real estate history, measured by the most accepted metrics-- price to rents and price to wages (see attached charts by Ned Davis Research). As stated in the "special report" written in 2003, residential homes were trading at the highest levels in history!! Now these same metrics have risen so far that they would have been off of the charts used in 2003. These rate reductions drove real estate (especially single family residences) to double in many areas of the Country from 2002 to 2006, even from these outrageous valuation levels. The main areas experiencing increases were Florida, Arizona, California, and Las Vegas. All of these areas are showing the greatest declines now.
The whole debt mess actually started with the Reagan Administration building up our military might like "Star Wars" during the "cold war" and driving up government debt in order to have a superior military force. The democrats were also not innocent bystanders in the debt build up as, under the Clinton administration, affirmative action lending policies were instituted in the 1990s that mandated Fannie Mae and Freddie Mac to increase purchases of mortgages for low-income borrowers and not to use racial discrimination (this was called redlining at the time). Banks were encouraged to make loans to people who were far from creditworthy. Another major problem came in 2004 when the brokerage industry pleaded their case before the SEC to increase their leverage from 12 to 1 to 40 to 1. Believe it or not, the SEC agreed to allow this ridiculous amount of leverage for investment banks-- and this allowed the industy to package all of these CDOs to sell to their clients both here and abroad.
The biggest problem still stemmed from the 13 rate reductions by the Fed that drove both stocks and home values higher. Chairman Greenspan also encouraged new home owners to take on the risky adjustable rate and teaser rate mortgages in 2003. You will find his comments in an earlier "special report" written in September 2003 titled "Real Estate-The Catalyst for the Deflationary Bear Market" below.
September 2003--"One of the amazing aspects of the massive refinancing of homes, which is effectively piling on consumer debt at record levels, is the fact that this is being done with the blessings of our esteemed Federal Reserve Chairman, Alan Greenspan. In various testimonies he has stated that borrowing the equity in consumers' homes is helping the economy and he supports it. Imagine the head of the Central Bank of the world's largest economy becoming a cheerleader for individuals to continue borrowing on the equity of their homes while they have already incurred a record amount of debt and the homeowners' equity is falling to record lows. Could the Fed Chairman actually think it is appropriate to use ones' home as an ATM cash machine?"
Home price increases generated a wealth effect even greater than the wealth effect of stocks during the financial mania of the late 1990s because home equity is a much more significant part of most individuals' net worth. However, it doesn't stop there-- the rise in home values and the feeling that it was a one-way street (real estate can only go up since they can't make more land) drove homeowners to take out additional loans on their homes to invest in more real estate, the stock market, and/or consume goods. You would think that homeowners would be able to understand that the outrageous increases in home values could not be sustainable. They must have been oblivious to the unprecedented increases that drove home values to at least double the norms relative to rents and median family incomes.
As you could imagine, the debt levels were driven to record highs and the amount of debt needed to be generated to increase $1 of GDP rose to records (chart we created and is published by The Chart Store showing this is attached). It now takes $3.50 of debt to produce $1 or GDP, up from $1.50 in 1982. What do you think happens to GDP under debt liquidations like we are experiencing now. This debt liquidation will continue as the housing prices continue their downward spiral as the excess inventories of close to five million homes is cleared out. This could wipe out as much as $6 trillion of wealth as housing values could drop to as much as $15 trillion from $21 trillion.
Superficially, it would seem as if the Fed can come to the rescue again. The problem with the Fed continuing to rescue the economy and stock market is that the total U.S. debt (both public and private) has increased substantially over the past 5 years to $49 trillion and the public sector debt is less than $8 trillion. The debt that has been generated by the private sector has grown to such a level that the Fed no longer has control. In fact, the main thing the Fed is accomplishing with these rate reductions and other "liquidity" measures is to drive down the US dollar. Soon they will realize that this is all they are accomplishing.
It is our contention that this latest "bull market" over the past five (2002-2007) years should have never taken place without a more significant recession (that would have reduced debt and encouraged savings) and a more severe stock market "wash-out". This would have gone far to correct the severe imbalances caused by the financial mania of the late 1990s, but unfortunately that did not happen. Right now the Fed is trying the same thing that seemed to work in 2001 & 2002. Actually, all they did was postpone what should have happened in 2003 to the present period. However, now they are attempting to manipulate the credit markets, stock market, and housing market by lowering rates, reducing regulatory restrictions (FRE & FNM), and encouraging special auctions to generate more "liquidity". They can throw as much liquidity as they have (about $900 billion-half committed-- unless they decide to print more) at the various problems as they sprout up, but it is futile.
The capitalistic system typically undergoes mild recessions that correct imbalances built up during the expansion. When these recessions are not allowed to occur, the imbalances just get worse and eventually results in a much deeper recession, or even depression. After the country goes through an incredible spending spree financed with debt, there has to be a period of cleansing. And if this indulgence is accompanied by almost everyone moving into homes they cannot afford or buying second and third homes based on unlimited credit, causing an incredible housing bubble that has to be corrected, it makes the problem much worse. There is nothing the Fed can do to stop housing prices from continuing to decline and commercial real estate will be the next shoe to fall.
The period of cleansing is called a recession, but if the government and Fed continue to interfere and maybe postpone it again, the recession might turn into a depression. Let's hope the Fed and the Administration realize what is inevitable soon, or it could really get nasty!!!