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Market Comment

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Putting It All Together

Fri, Nov 21 2008, 06:48 GMT
by Comstock Partners Team

Comstock Partners Inc.

We had been selling our research for many years before the year 2000, but after writing about the financial mania of the late 1990s, we felt that we were saying the same thing in every research report we wrote. "The savings rate was collapsing, debt was rising at an unprecedented rate (at every level), and the stock market rose to alarming valuation levels that could not possibly be sustained." Attached, we show a Ned Davis chart depicting the debt to GDP relationship over the past 6 decades, which shows why we were so concerned. We couldn't continue charging for reports that could have just said "ditto", so instead, we have been posting weekly comments and "special reports" on this site gratis.

During this time period we have discussed why this great country strayed away from the capitalist system that made it so great-- individual and business savings allowing productive investments to drive the economy. We moved to a system of greed and conspicuous consumption with money we did not have, driven by taking on enormous debt. We learned to lever up the system with debt-to-capital ratios as high as 40-to-1 by the largest investment banks in America. This spending did not stop with goods and services but also caused bubbles in stocks, bonds, homes, and commodities.

We were so frustrated at continually warning investors of the ramifications of the stock market bubbles in the late 1990s and 2003 through 2006 that we thought we were losing our minds. We watched the market's more rational behavior during the first few years of the new century and thought that the diligent work we were doing was finally paying off.
Then the market started up again in 2003 as we were writing about why the market had to continue declining until the public capitulated enough to drive the market to reasonable valuations. Instead, the market started up again when the Fed lowered interest rates to 1% and kept them there for a year, while the Fed Chairman encouraged prospective homeowners to take out complicated mortgages that were unaffordable to all but the very rich. This drove up home values from very expensive levels relative to incomes to ridiculous levels, while stocks started up from a very expensive 26 times reported earnings.

Although the bear market in stocks never found a good "wipe out" bottom and started a new "bull" market from levels typically associated with market peaks, those excesses paled in comparison to the subsequent housing bubble. We wrote a special report in September of 2003 describing why real estate would be the catalyst for the next deflationary bear market. At the time, median housing prices had just reached the record level over three times median household income. However, rather than correct from that level as they did in the late 1980s, this time they took off again reaching around five times median family income in 2006. This was unbelievable to us!! Finally, they reached the point of no return and started the descent heard round the world. The worst part about the U.S. housing bust was the fact that there was so much money involved. The total value of homes was in excess of $21 trillion owned by many individuals who bought more house than they could afford and/or bought second and third homes because of a universal belief that since they "can't build new land", home values could only appreciate. The value of the homes is now down to about $18 trillion on the way to $15 trillion or lower (another 20%) in order to get back to "just expensive". And, as we all know by now, the debt behind this real estate is enormous, and without government help will be very painful to unwind. The worst part is that the commercial side of the real estate problem has just started and could be even more painful.

During the period of rapidly accelerating house prices, virtually everything went up in the feverish environment based upon the wealth effect of the homes. There was a major concern about inflation since the homeowners used their homes as an ATM machine. In fact, many economists who warned about the inflationary implications overlooked the fact that debt was accumulated at unprecedented speed. In fact, for the two-decade period of the 1960s and 1970s it took approximately $1.50 of debt to generate $1 of GDP. The acceleration started in 1982 after stocks finally broke out of a trading range of around 700 to 1,000 over a sixteen year period. The bull market drove more and more individuals and businesses into a debt-related buying binge. The interest on the debt slowed down the growth in the economy relative to the increases in debt. During the 1980s and 1990s it took approximately $2.50 to generate $1 of GDP. This was only surpassed by the jump from $2.50 to $3.50 reached this year where it finally leveled off and we suspect will start a secular decline (see attached chart by The Chart Store).

Of course, there were other villains in the unconscionable build up in American debt. The present administration surely didn't help by lowering taxes on the wealthy just before we invaded Iraq. This war is now costing us about $9-$10 billion a month after the initial $13 billion cost of troop deployment. Some prominent economists are predicting that the War will cost around $2 to $3 trillion taking into consideration the costs of health care for the courageous soldiers serving in the Iraq War. If you include the War in Afghanistan it will be much more. The administration never stopped spending on other matters while these wars continued. Our public debt is now over $10 trillion and who knows what our interest rates would have gone up to if it weren't for our trading partners financing just about the whole thing. Let's hope that President Elect Barack Obama will get good advice and think through difficult decisions without the knee jerk reaction of the present administration. However, as stated in a recent weekly comment, he may see the tasks he has in front of him and demand a recount.

The spirit of spending money they don't have was not confined to the U.S. After all, our economy dwarfs the rest of the world with a GDP of about $14.5 trillion. The next largest is Japan at about $5 trillion, followed by China at $3.3 trillion and Germany at $3 trillion, France at $2.2 trillion, and the U.K. at $2 trillion and India at $1 trillion. When one country that has a consumer base with as voracious an appetite for goods and services from abroad as we do, what do you think happens when that same consumer base "hits the wall"?

To make things worse, because of our dominance world wide, most of our trading partners followed as we led them down the path of excess and greed. Wall Street decided to package up a bunch of toxic debt instruments and sell them to their customers both in the US. and abroad using leverage of 35-40 to 1. And, believe it or not, our trading partners gobbled them up with unparalleled speed. As they watched what we did, they imitated it and started speculating in homes they couldn't afford.

Now we face a global recession or worse and are attempting coordinated easing as well as massive stimulus packages all over the world. We really, really, hope that these coordinated bailouts will work and that everything will be just fine in a couple of months.
However, after watching the Japanese experience we suspect that this method of cleaning up debt financed excess spending will only prolong the inevitable real estate decline and lengthen the exit from the global recession (see special report, "How to Get Out of the Mess" 6/08).

This puts us in the same boat as we were in six years ago when the stock market was declining without the public liquidation we were expecting. Also, valuation metrics did not fall to the levels we expected. The main difference this time is that the P/E (the main valuation metric we use) was still very expensive at the lows in 2002 at 26 times reported earnings and 15.5 times trendline earnings. Presently, it is about 15.3 times reported earnings and about 11 times trendline earnings. We still expect the P/E will fall to secular bear market troughs of 10 times earnings or less and therefore expect the S&P 500 to drop to the 700 level or lower since the trendline earnings we use at Comstock is $66 in 2008 and $70 in 2009. Of course, if we use the estimated reported earnings of around $50 this year and next we would come up with a trough low of around 500 on the S&P 500.

We expect the public to liquidate equity mutual funds in a final capitulation that will drive the market down to approximately 700 or a little lower. This was written earlier and as we watch the action Thursday afternoon, the capitulation seems to be taking place. Of course, at extreme emotional times like these, the market pendulum could easily swing to the extreme levels of seven times the trendline earnings of $66 for 2008 or $70 for 2009-that would take us down to around the 500 area. We expect to get more positive on the market somewhere within that range.

• Diminishing Returns from Debt-Financing by Decade

• Dollars of Debt Required to Generate One Dollar of GDP

Published on  Fri, Nov 21 2008, 07:02 GMT