Comstock Partners, Inc.June 16, 2011
Why We Believe we are in a Secular Bear Market
Looking back at the long history of the U.S. stock market it is clear that there are long periods when the trend is distinctly up or down. We call these long trend "secular" markets as opposed to the commonly-known cyclical market trends that last about four years on average. In our view we are currently in a secular bear market that began when the market peaked over 11 years ago in early 2000.
The last half-decade of the 1982-2000 advance was accompanied by arguably the most spectacular financial mania of all time. Stocks, most often in the technology sector, typically went public and tripled on the first day of trading. The so-called dot.com stocks often had no earnings while others were merely concepts that didn't even have revenues. To justify the ridiculous prices of these stocks, analysts came up with new and untried metrics such as the number of eye balls that were viewing or would be viewing their websites rather than fundamentals such as earnings or cash flow.
You would have to think this secular bear market would be extremely severe with the combination of a major bull market followed by a financial mania. The market did decline by about 50% but the powers that be did whatever possible to delay or reverse the secular bear. Fed Chairman Greenspan tried to stop the severe stock market decline by lowering the Fed Funds rate to 1% in mid 2003 and keeping it at that level for a year. This move stopped the bear market in its tracks. The low rate enabled home prices to accelerate to the upside, and congress jumped in to help the Fed with the rescue by passing every law they could to make it easy for virtually anyone to buy a home. We believe that, even knowing the pain would have been severe, we should have just let housing prices and stock prices to fall to a level that would bring in "real" buyers.
The Fed intervention started the housing market on a tear (or bubble) since anyone who wanted to buy a home was able to do so by putting up little, or no money. Many of these loans were called "no doc" loans which meant that there was no documentation (like annual salary) required in order to get the mortgages approved. This caused a housing mania that was exacerbated when investment banks packaged the loans and sold them to their clients. They wound up selling packages of very poor quality mortgages (sub-prime) called "collateralized debt obligations" (CDOs) and convinced the rating agencies (who were paid by Wall Street) to rate these "securitized mortgages" AAA. To make things worse, most of the brokerage firms that understood the toxicity of these CDOs protected themselves by buying "credit default swaps", which were paid off when the loans defaulted.
Now, if the most significant bull market in U.S. history, that drove the stock market to "nose bleed" levels, followed by a dot com financial mania wasn't enough to start the secular bear market, what would? Well the market did drop by about 50% in 2000-2003 and was on its way to completing the secular bear. But, when the Fed induced a housing market mania accompanied by a cyclical bull market in stocks (within a secular bear) you would think that when the secular bear resumed it would be more severe and deeper. So far, it did produce another 50% decline in the stock market in 2008 and early 2009 as a credit crisis in 2007 caused the worst recession since the Great Depression.
The major 50% decline in the market also fit the same path as Japan as one of our "special reports" discussed in 12/2/2010 "Is America Following the Same Path as Japan?" Japan "hit the wall" after experiencing a similar stock market move from 1972 when the Nikkei 225 was trading about 2000 until the end of 1989 when it reached over 39,000 (18% compounded/year). If you recall it was in the late 1980s when everyone believed that Japan would take over all the manufacturing in the world. At one time the U.S. had a robust TV industry until Japan essentially took over the industry and made virtually every U.S. TV in the late 1980s. This move up in Japan was driven by excesses in the non-financial corporate debt side. That was when Japan corporations bought Pebble Beach and Rockefeller Center and anything else that was for sale. Japan paid the price for the excess debt- driven bull market that drove the Nikkei to almost 40,000 and now is under 10,000 over two decades later.
The key 18 year bull market we experienced here in the U.S. ending in 2000 was driven by excesses in household debt. Although wage growth had flattened out, consumers wanted a larger home, a nicer car, and nicer clothes whether they could afford it or not. If they ran out of money with their credit cards and bank loans they would take out a second mortgage on their homes that they felt could never decline in value. Household savings rates, which usually averaged about 9%, fell to near zero. Household debt as a percentage of GDP generally averaged about 50% of GDP and 65% of personal disposable income (PDI). However, starting in the early 1980s (as the stock market started this amazing bull market run discussed earlier) household debt rose to 100% of GDP and 130% of PDI by 2008.
Once the secular bear market started in 2000 we were convinced that the U.S. public had learned their lesson and would start to pay down their debt and begin saving again. We were wrong. After Greenspan lowered rates and started another financial mania driven by home values and the stock market, we were again convinced that the public couldn't be fooled again. However, after enormous bailouts of the largest financial institutions in the country, as well as the auto industry, and even more monetary ease than in 2003 (accompanied by TARP, the stimulus plan, QE, and QE2); we started another cyclical bull market within the secular bear market. The stock market went from severely oversold in March of 2009 to gaining 100% from those levels. We are convinced that, after the latest 100% rally since March of 2009, that this was the last time the public could be fooled again. And this time we are able to determine that consumers are saving more and consuming less; we believe this change in attitude will continue for a long period of time, creating severe headwinds against strong economic growth.
The most important question to ask yourself is, "can we have another major bull market in U.S. stocks anytime in the near future?" We believe the answer is a resounding "NO"! Just look at what took place in Japan after their stock market and economy "hit the wall" at the end of 1989. The private sector corporate debt that was primarily responsible for the most significant bull market in Japan's history continued deleveraging for decades. Government debt rose in order to replace the shrinking of the non-financial corporate debt (the debt that drove their bull market) that was either defaulted on or paid off. If the non financial corporate debt drove the market up during their great bull market, it only makes sense that their stock market (Nikkei 225) would decline as the deleveraging process was taking place. And that is exactly what has been taking place for the past 21 years (since 1989) as the Nikkei declined from almost 40,000 to under 10,000 where it is presently. We also note that during the past two decades Japan's GDP grew at an average annual rate of only 1%.
Why would we expect any different outcome in the United States as the household debt sector (the main sector that rose and drove the U.S. bull market of the 80s and 90s and also continued adding to the debt as the housing market took off from 2003 to 2007) is still in the process of deleveraging since 2007? That is just a little over 4 years, and we can expect a continuation of deleveraging for many years to come-we have a long way to go in order to get back to the levels of household debt relative to GDP or Personal Disposable Income (PDI). (See attached charts)
So the next question is, "How will the deleveraging affect the economy? And how will a weak economy affect corporate earnings? " If the deleveraging affects the U.S. economy the way Japan's deleveraging affected their economy over the past 21 years, it will clearly be highly negative for U.S economic growth. Since GDP growth and profits are positively correlated over time, that should negatively affect corporate earnings that have driven the stock market up for the past couple of years.
Now that operating earnings estimates for the S&P 500 have risen to the record levels of $100 again, we suspect that the deleveraging and weak economy will affect this estimate in a similar vein as in 2008, when S&P 500 earnings estimates were over $108 as late as May of that year. Actual earnings came in at less than $50 for operating earnings and less than $15 for "reported" earnings.