Comstock Partners, Inc.May 06, 2009
Green Shoots---Flowers or Weeds
Here We Go Again--They Never Learn
We seem to have a plethora of "green shoots" that we can all point to that indicate greener pastures for the economy and the stock market and we sincerely hope that they turn into the flowers everyone expects. However, we have to look at things as realistically as we can, and have in the past, when we were concerned about the dot com mania in the late 1990s and when we were concerned about the housing bubble from 2003 through 2007. The only thing that made sense to us over the past 13 years was the start of the secular bear market for a couple of years starting in 2000 and the financial unwinding starting in 2008. It would suit us just fine to be wrong about this thinking, but we also must express our analysis as we see it.
We went on a corporate, consumer and government binge that took our debt levels to the highest in all of history at about 370% of GDP. As most of you know we have been concerned for many years that the unwinding of this debt will take our country into a deflationary spiral that will not end until a significant amount of the private debt is wiped out-- either through defaults or being retired. We also do not expect the green shoots to produce the flowers that most envision until the secular bear market in stocks declines to the valuation levels of past bear market troughs.
Warren Buffet was interviewed on CNBC yesterday and stated that, "this market is not expensive but is not as cheap as it was in 1974". We don't disagree that this market is not as cheap as 1974, but would add that this market is also not as cheap as it was in 1933, 1937-38, 1941-42, 1949-51, 1980-82, 1987, and 1991. You can determine relative valuations by clicking on "Limbo, Limbo" (using NDR charts) on our home page to determine when the market was more or less expensive using the metrics of your choice. The one thing that is incontrovertible is that the market was much cheaper at the trough of every secular bear market. And in most instances we never got close to the bargain areas that were reached at the end of each secular bear market.
After these two bubbles bursting and the financial breakdown that caused a global meltdown, you would think the stock market will trade at the bargain levels of past major bear markets before this mess is resolved.
We also believe we will experience a final bear market capitulation of equity mutual fund liquidations that will drive us to these low valuations.
We were concerned about the oversold condition of the stock market in early March when it was the most oversold since the Great Depression, and bearish sentiment was reaching record levels. It was at that time that we expected the market to have a counter trend rally that would rise to about 20-25%. Since that time the S&P 500 has rallied more than 30% and has just broken through the strong resistance of 878 on Monday. The next resistance is at 944 and, as we have stated before, we don't expect the market to rise above 944 on the S&P 500.
However, with that said, we must understand that anything can happen over the short term before our strong belief that the excess debt will contract into a deflationary bear market. We sure didn't expect the financial mania of the late 1990s to drive the market up to valuation levels of almost double the prior market peaks while companies with no earnings and sometimes no revenues were going public and opening up 4 times the IPO price.
We also didn't expect another bubble to inflate in 2003 just because the Fed lowered interest rates 13 times from over 6.5% in 2001 to 1% in June of 2003 and kept it there for a year. The housing market was already at the highest valuation levels in history in September of 2003 (using the metrics of price to rents and price to median family incomes). Who could have believed that less than 3 years after the dot com financial mania that we could have another mania in housing? In 2003 the existing home price relative to family median income was just under 3 times family median income (which at the time was a record) and rose to 5 times family median income by 2006. And all this took place as banks were repackaging mortgages (many subprime) for Wall Street to sell to their customers both here and abroad. After the bubble burst in housing, the prices have still just declined to the extreme levels of 2003. It was during this latest housing bubble that the S&P 500 rose from 775 in 2002 to 1565 in October of 2007-all within the secular bear market we keep talking about.
The point we are trying to make is that if this country can experience two manias like this, what is to stop the market from rising above the 944 level (which is the highest level we expect) and even get up to 1000 or higher if there is a spreading fear among the public and money managers of missing the next bull market. There is a ton of money in money markets and short term treasuries that would love to get higher returns and this could cause the stock market to continue the counter trend rally to levels no rational investor could expect. Of course, this time there is nothing left to inflate after inflating the stock market in the late 1990s and the housing market in 2002, what's left?
With all of that said, we still expect the stock market to act more rationally and not to exceed the next resistance of 944 before resuming the secular bear market. We still believe the S&P 500 will eventually decline to10 times or less the smoothed earnings we are using of just under $60.