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Market Comment

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Headwinds vs. Tailwinds

Fri, May 16 2008, 06:14 GMT
by Comstock Partners Team

Comstock Partners Inc.

The headwinds to a bull market in stocks, as well as a stronger economy, seem to be much stronger than the tailwinds. It is truly astounding to us that this market is holding up so well right in the face of these headwinds.

The consumer, whose spending represents two thirds of our economy and who has been on a binge for the past 16 years is now facing head-on into the winds of the credit crunch, steeply rising commodity prices, and accelerating housing price declines. Businesses are also having a problem passing on the cost of rising commodities which are just starting to squeeze margins. There are not many tailwinds; however, the tax rebate should help for the months of May and June, but what then? The Fed has virtually acknowledged that the rate cuts are over and all the alphabet soup auctions they are promoting are at this point only lowering the U.S. dollar and increasing the price of commodities.

The rising cost of energy and food are acting as a tax on the consumer and are reflected in the retail sales numbers. Just about the only retail outlets that are doing well are the discounters such as Wal Mart and even they are warning that the increased sales will not continue into the second quarter.

Personal income growth has slowed to 4.5% (lowest since the last recession) while individual income taxes year over year change is 8%. The labor market is very weak as we have lost 256,000 jobs over the last 4 months. Consumer confidence is the lowest in 16 years. The savings rate is close to zero, and we are in the midst of the greatest credit crisis since the Great Depression. These are all major negatives, but the dominate headwind is the fact that the price of the most significant asset of most individuals, their house, is accelerating the decline by dropping by 7.7% in the first quarter (the largest decline on record). The wealth effect of this alone dominates everything else. It was just reported that homes up for foreclosure rose 65% this past April from April 2007, there are about 8 million homes with negative equity, and the prices are still well above the norm in relation to incomes and rents. We believe the residential home depression has already started spreading to the commercial side of real estate. And now the number of automobiles with negative equity is also exploding to the upside.

Businesses are not able to pass on the rising cost of commodities, and they have to sell their products to consumers who are "on the ropes". The three deficits (trade, current account, and budget) have reached the stage of insanity. The Fed has been monetizing the budget deficit, while the foreigners have accumulated much of our debt generated by the trade and current account deficits. These deficits have driven the dollar index down from 120 in 2002 to 73 presently. While this is good for the large international companies selling products abroad, debasing your currency in order to export goods over the long-term undermines the health of our country. This can be seen in our chart on the "cycle of deflation".

Corporations also have a problem in achieving the earning estimates that are being reduced weekly. And more importantly they will have a problem living up to the very high valuations placed upon them, even if they do meet the estimates. A 22 multiple on the S&P 500 "reported earnings" is typically only reached during market peaks. As we have mentioned in the last comment, the U.S. slowdown is now spreading abroad and most of Europe has the same creeping inflation that we are experiencing. This puts them in the same quandary as Bernanke on which battle to fight. Presently, the LEI (leading economic indicators) of both developing economies and emerging economies have declined to levels not seen since 2001.

The above are all major headwinds for the consumers and businesses, but the long term headwinds are even more important. These are the headwinds of paying down or even servicing the enormous debt built up by consumers and the government. The total credit market debt is up to the staggering $49 trillion level while the government debt makes up $9 trillion of that. The contingent debt pertaining to the programs already passed (and we are responsible for) are Medicare, Medicaid, Social Security, and the latest long-term cost of the Iraq War. Economists, Joe Stiglitz, in a book, "The Three Trillion Dollar War", recently released, projects the cost of the War at $2 to $3 trillion when you take into account the veterans medical costs. The cost of Medicare and Medicaid that are already extremely onerous (Medicare alone cost almost $400 billion this year) will skyrocket when the "boomers" retire. The social security's convoluted I.O.U. system, which substitutes for a fund, will be running into big problems when the number of retirees increases and the number of workers declines. We are spending $600 billion a year on oil imports from many countries that are hostile to us, and we still don't have an alternative energy plan.

Tailwinds-we wish we could think of more-we mentioned the tax rebate earlier, and that should help for the next couple of months. The stock market is breaking out, but it could be a false breakout since the market many times will break out in the opposite direction of the long-term trend, and the break out did not rise above the 200 day moving average and was not accompanied with strong volume. Many economists are backing away from their recession forecast due to stronger than expected economic releases recently. The markets usually do well after the Fed stops cutting rates, and also in Presidential election years. However, the number one tailwind is the fact that we are the greatest country on the planet and in the past we were always able to improvise and make the correct decisions in order to overcome almost any headwind. Let's hope we are able to so again-- this time in the face of these hurricane strong winds!!

Published on  Fri, May 16 2008, 06:16 GMT