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Market Comment

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Rally between the "Concern Stage" and "Fear & Capitulation Stage"

Fri, Jul 25 2008, 07:02 GMT
by Comstock Partners Team

Comstock Partners Inc.

Last Thursday we ended the comment by briefly explaining the sub-title of the report, "Rally between the Concern Stage and the Fear & Capitulation Stage" of the bear market. We stated at that time, "As we have indicated in past comments, we usually get a rally in the market between the three stages and explained the rally that moved us from the denial stage to the concern stage ("Three Stages of Bear Market", June 26). The rally that took place yesterday, and seems to be following through today, could be the rally that catapults the market into the very scary and nasty third stage, fear and capitulation. We will keep you posted". Well, the rally did continue and the S&P 500 has risen from close to 1200 at the bottom to 1291 so far.

As most of you know, we are still in the secular bear market camp and believe we will enter the last stage of the bear market within a month or so and we don't think the S&P 500 will rise above the 1360 area before the last stage begins. We have attached a Daily Graphs S&P 500 chart to illustrate what was explained in the June 26th comment about the first two stages of the bear market. We believe the "denial" stage of the bear market occurred from October, 2007 at S&P 500 1576 to March 17th low at 1257. The relief rally (between stages) got up to 1440 in May before entering the "concern" stage which drove the market down to close to 1200 before the relief rally that we are in presently. The relief rally we are in could go as high as 1360 or so in our opinion but could also end at virtually any time from this level up to the 1360 area.

Another attached Daily Graph longer term chart will show the similarity of the S&P 500 now compared to the bear market of 2000 to 2003. It rolled over back then from the 1550 area to eventually fall to under 800. We suspect that the third stage of this decline will take us to even lower lows than the 768 reached in 2002 and the 789 reached in 2003. We think the market will reach the valuation area of about 10 times earnings (P/E) that is typical of severe bear markets (estimates of S&P 500 earnings are in the mid $60 for 2008 & 2009 and these will probably be revised down). The only reason the market stopped falling to this area in 2003 is because the Fed lowered rates on Fed Funds from 5.25% to 1% and kept it there for a full year. This caused another bubble in housing while the dot com bubble bursting was not yet complete. The housing bubble started from past peak valuations in housing and took us to an outrageous doubling of those levels. It is our belief that the bursting of this housing bubble which is already down about 18%, will fall another 25-30% before it is over.

The housing depression will spill over into the commercial end of real estate in our opinion and that was somewhat confirmed in the release of the Beige Book yesterday. They stated that "commercial real estate activity slowed or remained sluggish in a majority of Districts". The real estate debacle will cause a severe recession in the U.S. that we believe will spread abroad. There are numerous examples of the contagion spreading abroad. Some examples are Eurozone vehicles sales were weak in June and factory output slumped. The German IFO (business climate index) was released today and dropped to 97.5 in July from 101.3 in June. That is the lowest level since November 2001. The Euro purchasing managers index was also released today and both the manufacturing and service sectors fell to 3 year lows. Italian business confidence fell to a seven year low. The Bank of Japan cut its growth forecast to 1.2%, the slowest in 6 years, and Japanese manufacturers' morale sank to a 5 year low in July as Asia as a whole is slowing down. The global recession will cause demand destruction in almost all commodities and should drive them much lower. Many investors believe that the stock market declined due to commodity prices rising. We disagree-we believe the commodity bubble bursting will coincide with a declining market. There will be very few central banks raising rates as competitive devaluations will be the norm (see attachment The Cycle of Deflation). This whole process should have a very negative influence on the economy and the stock market. We believe it will drive the S&P 500 low enough to take out the market lows of 2002 and 2003.

Even if you don't subscribe to the theory of the "three stages of a bear market", but are still concerned about the stock market we hope to give you ammunition to "stay the course". If, for example, you are concerned about the bubbles caused by the Fed and enormous greed of creditors as well as debtors, you should be. And if you are also concerned about the enormous problems of the three deficits (budget, trade deficit, current account) that are financed by our trading partners who now have so many dollars that they have found themselves to be more in control of this country than Congress or the Administration, you should be. If you are concerned that the consumer has "hit the wall" due to high energy and food prices, as well as lower real wages, record debt, and shrinking home values, you should be.

If these are your concerns, let us leave you with some facts that may help you "stay the course". We had major counter trend rallies in every bear market in the U.S. and most abroad. For example, in the Great Depression we had 6 counter trend rallies that averaged 30% from 1930 to 1932. Japan had 7 strong bear market rallies of at least 20% on the way down from 39,000 on the Nikkei Average in late 1989 to 7,400 in 2003. So, if this current counter trend rally rises above your comfort zone of not participating in the market, try to "stay the course" unless the market goes to new highs.

• The Cycle of Deflation
• Three Stages of Bear Market
• Long Term Chart Showing Similarity to Last Bear Market.pdf

Published on  Fri, Jul 25 2008, 07:05 GMT