Author Archive for Comstock

It’s 2000 & 2007 All Over Again

By Comstock Funds

“I have to get into this market; otherwise it’s just dragging on me” (A portfolio manager quoted in the Wall Street Journal just prior to the March 2000 peak in the S&P 500.)

“..as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” (Citigroup CEO Chuck Prince in July 2007) You know how that turned out.

It’s that time again.  The Dow surpassed its all-time high and the S&P 500 is not that far from the tops of 1553 on March 24, 2000 and 1576 on October 9, 2007.  Just as in 2000 and 2007, the economic, valuation and political background does not support the budding euphoria.

The economy has been limping along at about a 2% growth rate despite the near-zero percent Fed Funds yield and huge amounts of Fed bond purchases.  At the same time fiscal policy has become a significant headwind.  The agreement to avert the fiscal cliff could slice about 1% off GDP with the sequester reducing it by another 0.5%.  A 1.5% hit to a GDP that was only growing at about 2% leaves the economy on awfully thin ice, and very close to recession.  Consumers are still in the process of deleveraging their debt, and with wages climbing so slowly, are in no position to go on a spending spree anytime soon.  Businesses, sensing a lack of consumer demand, and worried about the dysfunction in Washington, are not likely to step up capital expenditures to any great degree.  Unlike the stock market, they are building up their cash in anticipation of the next crisis.

The market has climbed on the basis of an almost childlike faith in the Fed as well as record corporate profits.  As we have previously stated the Fed has not been successful in channeling money into the real economy.  Moreover, corporate earnings growth has come to halt and is threatening to turn down.  In fact, third quarter S&P 500 operating earnings declined from a year earlier, and fourth quarter reports seem to be falling short as well with the vast majority of companies having already reported.  Two quarters of declining year-to-year earnings growth has been seen only in recessionary environments.  Earnings for the full year were up a miniscule 0.6% from 2011.

Although earnings estimates have been coming down analysts are still forecasting an increase of 14.7% for 2013 and another 12.8% for 2014.  This outcome is highly unlikely, and will probably disappoint on the downside, particularly in view of the decline in fourth quarter productivity.  In April 2012 the consensus forecast for 2012 operating earnings was $104.89, and ended up at $96.99.  Even the prediction for 2013 has been reduced to $111.28 from $118.85.  If anything, the downward revisions appear to be accelerating.  Fourth quarter earnings turned out to be 13% lower than forecasts made as late as September. To make matters worse, profit margins are at historical peaks, and whenever this has happened margins have reverted to the mean.

Rosy forward-looking earnings forecasts that come crashing down are nothing new for the market.  These forecasts are almost always wrong, and most often on the high side.  In mid-2000 the forecast of forward operating earnings was $64 and eventually came in at $38. At year-end 2007 the consensus estimate for 2008 was $89 and remained there until the end of May.  Even at the end of October, only two months from year-end, the estimate was $72.  The actual number came in at $46 just a few months later. The estimate for 2009 was even more laughable at $110 in May 2008.  At year-end it was still $99, but eventually ended up at only $57.

Given all of the problems with using forward operating earnings as a measure of market valuation, it’s amazing that it continues in such widespread use.  Currently, a large number of analysts are using the 2013 operating earnings forecast of $113 in estimating the P/E ratio at 13.7, which they regard as reasonable or even slightly undervalued. History, however, indicates that such euphoric forecasts at turning points are often hugely overestimated.  When the actual earnings are reported it becomes apparent that the P/E ratio was far higher than it appeared at the time.

We also note that for the purposes of this comment we have gone along with the “Street’s” predominant use of operating earnings.  As long-time readers know, we prefer the use of trailing cyclically-smoothed reported (GAAP) earnings, which gives a truer picture of valuation.  On this basis the P/E ratio is about 19, which would be highly overvalued for any time before the series of bubbles that started in the late 1990s.

The 4 Dubious Assumptions Driving the Market Higher

By Comstock Partners

Despite the problems facing the U.S. economy, the dysfunction in Washington and slowing global growth, stocks continue to rise on the basis of what we view as false assumptions.  These assumptions are as follows:

1)     Since almost every central bank in the world is aggressively easing, the market cannot go down.

2)    Although the U.S. is facing a fight in Washington over the debt limit, the sequester and the expiration of the annual federal appropriation, various political threats over the last two years have passed without substantial market damage, and the same will happen this time.

3)    S&P 500 earnings will rise to $108 in 2013, resulting in a current P/E multiple of only 13.7.

4)    The economic recovery will kick into full gear once the problems in Washington are solved or again “kicked down the road.”

We disagree.  Despite massive ease by the Fed and stimulative fiscal policy, the economy has grown at only a 2.2% annualized rate since the recovery started in the 2nd quarter of 2009.  That pales in comparison to the average of 3.6% between 1950 and 1999—-and that period included both recoveries and recessions. The Fed, however, has run out of ammunition.  The funds rate has been near zero since 2008 while each successive round of quantitative easing has had less and less effect.  GDP estimates for the 4th quarter of 2012 are only between 0.5% and 1.5%. Economic growth has shown few signs of being sustainable on its own.  It is worth pointing out that GDP growth has consistently been overestimated throughout the recovery.  The Fed, for instance, originally forecast GDP growth of 4.5% for 2012.

Moreover, fiscal policy, which has previously been supportive of economic growth, is fast becoming a headwind instead.  The fiscal cliff agreement, although celebrated by the market, raised taxes and reduced spending by enough to slice between 1% and 1.5% off GDP this year.  No matter how the upcoming debates are resolved, they are all about cutting deficits through some combination of spending reductions and tax increases.  A portion of this will be applicable to 2013, and result in additional deductions from economic growth.

In our view S&P 500 earnings for 2013 will come in far under the $108 forecast by the consensus.  Earnings in the 3rd quarter were substantially under predictions made earlier in the year while revenues were about flat year-over-year. The 4th quarter results are likely to be no better.   Furthermore, cyclically smoothed reported (GAAP) earnings are only at about $75, meaning that the market is significantly overvalued, rather than cheap.

Investors are also ignoring the headwinds from slowing growth or recession across the globe.  Europe and Japan are in recession while China is slowing down, meaning that the export-dependent emerging economies will be hit as well.  The new Japanese government has now taken actions to devalue the yen in order to increase exports.  This is already increasing the strength of the euro to the consternation of the EU, which is likely to take action to defend its currency.  The potential result is a global currency war in which everyone loses.

Investors think that once Washington gets its act together the economy will be off to the races. We doubt that will be the case. For about 25 years consumers binged on debt and reduced their savings rates as real household income stagnated.  We are now in a period where consumers will be paring down debt and raising savings rates, resulting in tepid spending at best for some time to come.  In this kind of climate capital expenditure growth will also remain sub-par in response to lack of demand for products and services.

The cyclical bull market is now almost four years old and is close to the historical average in terms of both amplitude and duration.  At this point it is out of sync with economic growth and valuation, and the risks seem far greater than the potential rewards.

The Disastrous Consequences of not Raising the Debt Ceiling

By Comstock Partners

As we face another brutal fight over the federal debt ceiling at a time when the economy still remains fragile, the stock market is oddly complacent.  Even if the debt ceiling crisis is resolved, the result would be some combination of spending cuts and tax increases that would weaken the economy in 2013.  A settlement, however, is far from a done deal as both sides remain far apart and determined to defend their positions.  Far worse, if the debt limit is not raised or eliminated, the effect on the economy and markets could be disastrous.

Republicans are insisting on major spending cuts in exchange for raising the debt limit while President Obama is adamant in saying that he will not negotiate on that basis.  A number of Republicans have voiced the opinion that government shut-downs have occurred in the past without any great consequences, and that we can do it again.  However, a failure to reach agreement this time would involve not only a shut-down, but a failure to pay many billions of dollars of U.S. government obligations, something that has never happened before in the U.S.  On the other hand, it is not clear how Obama can avoid negotiations over the debt limit, as other proposals floating around appear to be unfeasible or unconstitutional.

This week the Bipartisan Policy Center issued a 41-page report detailing the disastrous consequences of not raising the debt limit.  We outline the report as follows.  The full report can be found at www.bipartisanpolicy.org.

The U.S. government hit its debt limit on January 1st. The Treasury secretary then tapped into the $201 billion emergency borrowing authority to allow for an additional period of fully-funded government operations.  It is estimated that the emergency funds will run out sometime between February 15th and March 1st.  After that, the government can pay out only what it receives in revenues, which covers only about 60% of the obligations due between February 15th and March 15th.

The Treasury then has two choices as to how to make the payments.  It can make all of each day’s payments once enough cash is available.  In this case all payments would be late, and they would get later and later with the passage of time.  An exception could be made for interest payments on the debt so that no default actually occurs.

The second choice would be to pay some bills on time while others would not be paid.  It is unclear whether this method is legal or even feasible, given the design of the Treasury’s computer system.  The department makes about 100 million individual payments monthly, and would be forced to pick and choose which ones to make and which to skip.

The problem is that the monthly cash inflow would be roughly $277 billion and the obligations at $452 billion, leaving $175 billion unpaid.  Let’s suppose that Treasury chooses to pay interest on Treasury securities, IRS tax refunds, Medicare and Medicaid, Social Security benefits, military pay and retirement, and unemployment insurance benefits.

That would eat up all of the cash flow leaving the following items unfunded:  defense vendor payments, veterans’ benefits, federal salaries and benefits, Pell grants and special ed. programs, food and nutrition services, civil service retirement payments, health and human services grants, supplemental social security income, the Department of Justice, the FBI, the federal courts,  the Department of Energy, the Federal Highway Administration, the FAA (air traffic control), the Environmental Protection Agency, FEMA and the National Flood Insurance Program.  These payments and non-payments can be calculated in other combinations, but the point is that about $175 billion of obligations can’t be funded.

The disastrous consequences of not increasing the debt limit are easy to see.  It amounts to a sudden 39% decrease in government spending, resulting in severe recession, plunging global markets, rating agency downgrades, widespread uncertainty and public unrest.  Moreover, the damage to the credit rating of the U.S. would lead to far higher interest payments for years to come.

In our view the stock market is not discounting either the disastrous consequences of not raising the debt limit or the still negative growth impact of additional spending cuts and tax increases. The S&P 500 is near a 5-year high while the VIX volatility index is at its lowest point since May 2007. All in all, it is similar to the conditions in early 2000, when the market ignored the vulnerability of the dot.com boom and late 2007, when the “experts” ignored the importance of falling home prices and record household debt.  In both cases the S&P 500 plunged about 50%.

It’s Not All About the Fiscal Cliff….

By Comstock Partners

While the fiscal cliff problem has absorbed almost all of the financial media comment since the election, there’s a lot more to the stock market decline that has virtually gotten lost in the discussion.  The market actually topped on September 14th and has trended down ever since.  Most importantly, the U.S. economy was a lot weaker than the consensus believes before Hurricane Sandy became a factor.  In addition Fed policy is becoming increasingly ineffectual, earnings forecasts are coming down, Europe is officially in recession and China, as well as the other BRIC nations, is slowing down.

Although nobody knows the outcome of the fiscal cliff situation, it is likely to be settled, if not before year-end, then in the first part of 2013.  However, even if this happens, the solution will probably entail some combination of lower government spending and increased revenues—-in other words, a tightening of fiscal policy. While a solution is surely better than a continuation of confrontation, a tightening of fiscal policy creates further headwinds for the economy in the shorter term.  Moreover, an agreement on the fiscal cliff does not solve all of the other serious problems facing the economy and the market.

Most serious of these problems is the U.S. economy itself. Although it may be doing better than most other countries, that is damning it with faint praise.  Specifically, the highly-touted consumer recovery, when examined closely, is built on quicksand.  Yes, after lagging earlier in the year, real consumer expenditures has jumped by 0.9% over the last three months. However, during that period real disposable income actually declined by 0.2%.  Therefore, it can easily be seen that this decline was more than overcome by a drop in the consumer savings rate from 4.4% in June to 3.3% in September.  In fact, while expenditures climbed $83.9 billion in the three-month period, savings decreased $130 billion, clearly an unsustainable situation.  While Hurricane Sandy will muddy the statistical waters for the next month or two, the strength in consumer spending is almost sure to diminish beyond that point.

In addition, the outlook for capital expenditures is lackluster as well.  New orders for durable goods ex-transportation and defense, a leading indicator of future capital spending, have declined 9.1% since year-end and 7.7% since May.  This is likely to lead to softness in industrial production too.  With consumer spending and capital spending accounting for the vast majority of the economy, overall growth is likely to falter in the period ahead.

With the economy likely to soften at a time when fiscal policy is about to tighten, corporate earnings estimates coming down and Fed policy increasingly ineffectual, the factors that have sparked the stock market in the last few years have come to an end.  In our view, this is readily apparent in the change in trend since the peak on September 14th.  We think that will turn out to be the top for some time to come.

The Fed’s Determined, but its Tools are Limited

By Comstock Partners

The Fed’s initiation of QE3 (or QE Forever) is a desperate attempt to fight off the severe headwinds that are still hampering the economy four years after the onset of the credit crisis.  For months now the market has been almost completely dependent on the Fed and the ECB as they are virtually the only game in town, while everything else is seemingly going downhill.  Most of the global economy is either slowing down or already in recession, while corporate earnings that also propped up the market for so long are now being revised downward.  The market is facing uncertain elections, a paralyzed federal government and the highly publicized but still dangerous fiscal cliff.

Underlying the malaise in the economy is the vast overhang of household debt and low savings rates that is discouraging robust consumer spending.  Households are in the process of increasing savings rates and reducing debt, restricting their buying to what is necessary or to replacing aging goods.  In addition consumers are suffering from weak employment, minimal wage increases, lower net worth and scarce credit that is available only to prime borrowers.  Although corporations are already flush with cash, they have little incentive to expand or hire people in the face of light demand.

In response, the Fed, decided to initiate QE3, a program to buy $40 billion a month of mortgage-backed securities on an open-ended basis in addition to the $45 billion in operation twist that ends in December.  In addition the Fed extended until mid-2015 the period during which it keeps the funds rate between zero and 0.25%.  In his press conference following the FOMC meeting, Chairman Bernanke stated that the pace of economic growth was inadequate to bring down the rate of unemployment that is unacceptably high and that the Fed intended to employ tools that would bring the unemployment rate down.

Bernanke made it clear that the Fed’s tools were limited and that the Fed could not fix the economy by itself.  He stated that their tools were meant to boost asset prices—-namely housing and stocks—-and to make their communications transparent.  To this end the bond purchases were meant to goose asset prices while the extension of monetary ease to mid-2015 was intended to show strong commitment.

In our view the Fed’s policy will not be effective. Although QE1 was effective in saving the financial and economic system from collapse, QE2 and operation twist did not result in much economic growth and we are approaching a point of diminishing returns.  In fact, QE3 could well have some undesirable results as well.  The Fed’s action was immediately greeted with a rise in long bond yields, a jump in wide array of commodities and a weaker dollar.  While some were quick to see this as inflationary, it is more likely to reduce real consumer income and ultimately be deflationary.

It therefore appears that QE3, far from being a panacea, is a desperate attempt to do something when nothing else is working. Current quarter GDP appears likely to become the third quarter out the last five to show growth below 2%.  S&P 500 earnings estimates have started to drop, a process that is only in its early stages.  Europe’s problems are well known, and as we mentioned last week, are far from solved.  China’s investment bubble is fading while net exports are declining at the same time that the goals of reducing savings and increasing consumer spending are not being met.  Japan’s economy is in a third lost decade and the BRICs other than China, with their export-oriented economies, are also having problems.  Despite last week’s rally, we don’t think the stock market has much going for it under current and prospective conditions.

Why the Market Looks Toppy

By Comstock Partners

The market is giving signs that it has discounted any possible good news and that the rally is over.  Europe has been in one of its periodic, but temporary, quiet periods that has encouraged the market while slipping further into recession.  At the same time the long-term policy moves required to unify the EU is not likely to be accomplished before a capital flight from Italy and Spain forces their hand. The global economy continues to slow, including, in addition to Europe, the U.S., China, India and Japan.  While some form of Fed easing seems probable, the results are not likely to matter as monetary policy is becoming less effective and fiscal policy is paralyzed.  Corporate earnings estimates are starting to come down and results for this year and next will be highly disappointing.  Technically, the market appears to be in the process of completing a top.

Greece once again needs more funds in order to avoid bankruptcy and an exit from the EU.  If Greece is forced to leave the EU, it could set off a chain of events that would break up the zone.  The EU agreed to give Greece a bailout of 173 billion Euros just a few months ago, and is now reluctant to put up even more funds.  German Chancellor Angela Merkel’s coalition partners are opposing any more aid to Greece and there is major opposition to the move in the Netherlands, Finland, Estonia, Slovakia and Austria.

The problem for Germany is that, as an export-oriented economy, it needs the EU to stay intact.  The creation of the EU was like a magic wand that bestowed a triple A rating on all of the southern tier nations and enabled them to easily raise the funds that enabled them to buy German goods.  This enabled the German economy to grow substantially, and it has a lot to lose if the EU breaks up.  Ever since the start of the crisis almost three years ago Germany had to know that it would have to absorb the major part of the cost of solving it, but has been working all this time to get the best deal it could.  That is why we have seen the continual maneuvering and delaying tactics by all sides as they tried to buy more time.

Now the end-game is rapidly approaching.  Greece is estimated to run out of funds in October.  The next ECB meeting is on September 6th; the German constitutional court rules on the EU rescue fund September 12th; and the next EU summit is on October 6th.  Meanwhile the headlines are likely to mean a great deal of volatility for the markets.  Even more importantly, however, the outcome will either cost Germany a huge amount of money, substantially weakening its outlook, or will result in the breakup of the EU.

At the same time, global debt deleveraging is placing a lid on world economic growth, which is now slowing once again as we have discussed in recent comments.  In the words of Caterpillar CEO Doug Oberhelman, “The global economic outlook is more uncertain than at the start of the global crisis in 2008.”  While experts disagree on whether China will undergo a soft or hard landing, the Shanghai Composite is now down almost 40% from its post-recovery peak in August 2009.

The market recently has been placing a lot of faith in ability of the Fed to ease our way out of our economic problems.  Although the latest Fed minutes indicate that imminent easing is a strong possibility, we believe the potential effects are being over-rated. Successive easing measures have had diminishing benefits and the Fed has used all of its conventional tools.  Any remaining weapons are unorthodox, untried or subject to unknown negative consequences.

We also believe that the lengthy period of ever-increasing corporate earnings is coming to an end. Only 41% of the S&P 500 beat revenue estimates, the lowest in three years.  Five companies issued negative outlooks for every company that was positive.  Third quarter earnings estimates are now down 1.5% from a year-earlier.  If so, it would be the first down earnings quarter in three years. In our view we are going to see a cascade of downward revisions to earnings over the next six months.

It seems to us that the technical outlook for the market has also turned negative.  On Tuesday morning the S&P 500 made a new recovery high before backing off.  This high, however, was not confirmed by the Nasdaq Composite, the small cap 600, the mid-cap 400, the Dow Industrials, the Dow Transports, the NYSE Composite and the Russell 2000.  The number of daily new highs has been dropping on the latest rally.  Last Friday the VIX dropped to 13.45, a number that has signified market tops over the last few years.  This indicates a market that is highly complacent and far from fearful as a lot of pundits would have you believe.

The Market is in Denial Over Bad News

By Comstock Partners

Global growth continues to slow.  Of the major economies, the Eurozone is in the worst shape, with output dropping 0.7% in the second quarter.  Even the German economy has been plodding along with a rise of only 1.1%, while business confidence declined for the 4th straight month.  New orders declined by the largest amount in three years.  France’s output was down 0.2% with unemployment over 10%.  Leading retailers have reported declining sales while auto manufacturers have been cutting production.  2nd quarter output fell 2.9% in Italy and 1.7% in Spain.  Greece continues to be a disaster.  The news from Europe has been in one of its periodic quiet periods, allowing the memory-challenged U.S. market to temporarily ignore it once again.  It will probably not be long before the stresses and strains hit the headlines again with usual dismal results.

The U.S. economy has continued its extremely slow growth pattern, looking good only by comparison with the EU.  July retail sales picked up after three consecutive down months.  With weak employment, low savings and the need to deleverage debt, consumer spending is likely to remain weak.  The Philadelphia Fed Survey was negative for the 4th straight months and the New York Empire state survey was below zero for the first time since October.  The important small business survey was down for the 4th time in five months with particular weakness in revenues and profits.  Although there has been a lot of talk about a housing rebound, the mortgage purchase index declined for the 5thconsecutive week, and is down 8.6% over the last four weeks and 11.3% over the past year.  We previously pointed out that existing home sales are at their lowest level since October and that pending home sales declined in June.

China’s growth has been slowing even according to the suspect official figures.  2nd quarter GDP growth of 7.6% was the weakest since the 2009 global crisis and industrial production was up 9.2%, the lowest rate since May 2009.  A number of economists who are familiar with Chinese economics, politics and culture believe that the actual rate of growth is much lower than the official figures show.  Both China’s exports and imports have been falling, thereby impacting growth of many other nations as well.

Despite the underlying malaise, the market has been undergoing a low volume rally that has carried the S&P 500 close to its April 2nd peak on the grounds that the central banks of the major nations would implement easing measures that would prevent any recession and that ,since the bad news is well known, it is most probably discounted.  In our view this is the typical denial we often see at market tops.  With interest rates already so low and central bank books loaded with assets, there is not much more they can do except attempt non-traditional remedies with uncertain and, perhaps, unwanted outcomes.

We also doubt that the market has discounted the bad news at a time when the S&P 500 is up 112% over the past 42 months. Just because bad news is well-known does mean that it is automatically discounted.  Take October 2007 for instance.

At the October 2007 market peak there was also plenty of bad news out there that didn’t matter until it did.  By October 2007, investors already knew that 1) the housing industry was collapsing; 2) various mortgage lenders such as H&R Block, Countrywide, Impac Mortgage and Accredited Home Lenders had come public with their serious problems; 3) Washington Mutual revealed improper loans totaling $30 billion; 4)  large numbers of loans were adjustable-rate, interest-only, not backed by documentation of assets and income and topped with a home equity loan granted at the same time; 5)  we had learned how mortgages were sold and packaged, sliced and diced and sold throughout the globe; 6)  we learned about an alphabet soup group of securities few had ever heard of before; 7) large numbers of mortgage companies were taking huge write-downs and going out of business; and 8) two big Bear Stearns hedge funds came close to collapse.

Despite all that, Wall Street still didn’t get it.  In August 2007 a typical guest on financial TV casually referred to all the market turmoil as “financial gamesmanship” as opposed to what he termed “solid economic fundamentals”.  He was far from alone in his thinking.

In our view the same sort of denial is going on now.  Investors are overly reliant on central bank action that has a good chance of being ineffective or worse.  The bad news, despite being well-known, is essentially being ignored.  Rather than concerned, the market seems to be unusually complacent.  The S&P 500 volatility index (VIX), commonly known as the “fear index” is now down to 14.6, compared to 15.6, 14.1, 15.6 and 17.4 seen at the respective market peaks in April 2012, April 2011, April 2010 and October 2007.

The Market is Tracing out a Typical Topping Pattern

By Comstock Partners

With the global economy likely headed for another recession, central banks are still attempting to step up their probably futile effort to stop the downward tide by trying to boost stock market prices. Although we are generally not believers in conspiracies, it does seem likely that the Fed, late yesterday (Wednesday) afternoon, leaked the possibility of an imminent move toward more ease to its favored reporter at the Wall St. Journal. Not coincidently, the report came out just as the S&P 500 was breaking below the upward trend line in effect since the June 1st bottom. To add icing to the cake, ECB head Mario Draghi, a few hours later, announced the ECB’s intention to do everything it could to keep the Eurozone together.

The leak by the Fed was most likely a signal that the move toward more ease would come about at next week’s FOMC meeting, as anything less would meet with severe disappointment by the market. By the same token, the ECB, too, will now have to follow up with something more concrete than Draghi’s general statement.

In our view, a global recession is probably in the cards despite any actions by the world’s central banks (Please see last week’s comment in the archives). While the central banks may have temporarily halted the potential downward break in the stock market, we believe that the peak has already been made, and that the market, at its own pace, is tracing out an extended topping process typical of many past bear markets.

If we look at the five bear markets that started in January 1970, January 1973, August 1987, September 2000 and October 2007 we can see a similar pattern where the market declined after a peak, rallied to a level below the previous peak and then plunged to a final low. In each case the first decline was relatively benign and mistaken for a correction in a bull market, while the next decline from the interim top was severe and left no doubts.

The first drop after the peak was between 8% and 19% and took one to seven months. The subsequent rally was between 6% and 12% over 1 to 2 months and fell short of the previous peak. From that point the final leg down was between 23% and 52% over anywhere from 2 to 12 months. The total decline from top to bottom was between 26% and 57%.

In the current cycle the S&P 500 peaked at 1419 on April 2nd, and dropped to 1278 on June 1st, a 9% drop over 2 months. The following rally has so far topped on July 19th, a gain of almost 8% over 7 weeks. These are within the parameters of prior bear markets. If this market plays out as prior bear markets, which we expect, the next decline will be extremely severe.

Evidence of Coming Recession is Overwhelming

By Comstock Partners

We first noticed the first signs that the economy was beginning to soften about three months ago.  Now the evidence of a slowdown has become so overwhelming that it is difficult to avoid the conclusion that we are headed for a recession.  We cite the following as evidence.

Retail sales (both total and non-auto) have dropped for three consecutive months.  This has happened only five times since 1967—-four times in 2008, and one now.  Vehicle sales have tapered off with May and June being the two weakest months of the year.  Consumer confidence for both the Conference Board index and the University of Michigan Survey are at their lowest levels of 2012.

On the labor front, June payroll numbers were weak once again and averaged only 75,000 in the second quarter. The latest weekly new claims for unemployment insurance jumped back up to 386,000 and the last two months have been well above the numbers seen earlier in the year.

The ISM manufacturing index for June fell 3.8 points to 49.7, its first sub-50 reading in the economic recovery.  The ISM non-manufacturing index for June dropped to its lowest level since January 2010.  Most recently the Philadelphia Fed Survey for July was negative (below zero) for the third consecutive month.

The small business confidence index declined in June to its lowest level since October and has now dropped in three of the last four months.  Plans for capital spending and new hiring have dropped sharply.

Despite all of the talk about a housing bottom, June existing home sales fell 5.4% to its lowest level since the fall of last year.  In addition mortgage applications for home purchases have been range-bound since October.

Core factory orders, while volatile on a month-to-month basis, have declined 2.6% since year-end, and the ISM numbers cited above indicate the weakness is likely to continue.

The Conference Board Index of leading indicators has declined for two of the last three months and is now up only 1.4% over a year earlier, the lowest since November of 2009, when it was climbing from recessionary numbers.  The ECRI Weekly Leading Index is indicating a recession is either here now or will begin in the next few months.

The breadth and depth of the slowdown are greater than the growth pauses experienced in mid-2010 and mid-2011, and indicate a strong likelihood of recession ahead.  In addition the foreign economies will be a drag as well.  A number of European nations are already in recession and others are on the cusp.  The debt, deficit and balance sheet problems of the EU’s southern tier are a long way from any solution, and will not remain out of the news for long.  China is coming down from a major real estate and credit boom, and is not likely to avoid a hard landing.  The Shanghai Composite is in a major downtrend, declining 28% since April 2011.  The view that China is immune because of their unique economic system reminds us of what people were saying about Japan in 1989.

The stock market is ignoring these fundamentals as it did in early 2000 and late 2007 in the belief that the Fed can pull another rabbit out its hat.  It couldn’t do it in 2000 or 2007 when it had plenty of weapons at its disposal.  Now there is little that the Fed can do, although it will try since it will not get any help, as Senator Schumer so aptly pointed out at Bernanke’s Senate testimony.  In sum, we believe that the stock market is in store for a huge disappointment.

The Bear Market is Only Beginning

By Comstock Partners

Long before it became headline news, we were talking about the corrosive effect of excessive debt, the softening U.S. and global economy, the “fiscal cliff”, the implausibility of a European solution, the probability of a hard landing in China and the prospect that corporate earnings estimates were far too high. Now these negative stories are carried in the Wall Street Journal every day.  This week alone carried articles on downward earnings revisions at major corporations, Brazil’s sputtering growth, the worsening slowdown in China, new austerity measures in Spain and Italy, the continuing disappointment in U.S. economic indicators and more worries about the fiscal cliff. As if that were not enough, the news has been full of reports on the fixing of Libor rates, the fraud at Peregrine Financial and the J.P. Morgan losses.

In the face of the now-obvious negative outlook, the question we get most often is why the market has declined so little and why it seems so resistant to bad news. In our view the reluctance of the market to give up much ground is typical of many past market declines and reflects a state of denial by investors as they grasp at reasons to remain bullish.  Currently, the reasons cited most often are that the market is cheap, corporate earnings are strong and the Fed as well as other central banks will provide all the liquidity that’s needed to avert a serious economic downturn.  We believe that each of those evaluations is flawed.

The current earnings estimates for 2012 are unlikely to hold up and the market is not undervalued.  The consensus estimate for S&P 500 operating earnings is about $104 for 2012 and $118 for 2013.  The bulls simply multiply the 2012 estimate by 15 and come up with a prospective S&P of 1560 (usually something between 1500 and 1600).  Various studies, however, indicate that the more relevant method is use a trendline estimate of reported (GAAP) trailing earnings.  Our estimate of trendline earnings is currently about $75, and, on this basis, the market is overvalued rather than undervalued.  The problem is that estimates of forward operating earnings are almost always wrong by a wide margin, most often on the high side.  In May 2008, for instance, the estimate for 2009 was $110, and eventually came in at $57.  In this regard, it is noteworthy that although the second quarter earnings report season has barely started, 42 major corporations have already guided their estimates down.  (For more detail on this topic, please see our comment of April 5, 2012, in our archives).

In a similar vein, we believe that investors’ faith in the ability of central banks, including the Fed, to avert a serious downturn is ill advised.  In 1999 and early 2000 we had the so-called “Greenspan put”, which referred to the supposed ability of the Fed to avert a recession.  Despite the fact that it didn’t work, investors still had great faith in the so-called “Bernanke put” in 2007, and we now know how that worked out.  Despite the disastrous outcome in those instances, investors now seem to have great confidence in a global central bank put.  In our view global debt deleveraging will overwhelm any central bank attempts to prevent a serious downturn, particularly when we take into account that central banks have already used their best ammunition and have to rely on unconventional and untried measures with questionable chances of success.

In the last four major bear markets the decline started very slowly from the peak, and was interrupted by numerous rallies, but continued to gather steam, ending only after a scary waterfall decline toward the end.  We suspect that the same pattern may happen this time around.

The Global Slow-down Will Accelerate

By Comstock Partners

Slowing growth as well as deficit and debt problems in the Eurozone, U.S., China and the emerging nations increases the odds of a deflationary global recession and a renewed down leg in the ongoing secular bear market.

The Eurozone crisis is worsening as economic growth is being hit by front-loaded austerity measures that is exacerbating budget deficits and reducing tax revenues.  The southern-tier nations, particularly Spain and Italy, cannot get credit as interest rate spreads have widened to unsustainable levels.  Funds have been flowing out of the disadvantaged nations and appear on the verge of a full-fledged run if financial aid in some form is not provided in the very short term.

As we write, the EU is meeting in emergency session to take up measures to shore up the finances of Spain and Italy with the hope that they can buy enough time to start planning on longer-term solutions.  For the last two years the EU has enacted one emergency bailout after another only to have to come back and try again within a short time.  Most likely, they will come up with another short-term plan this time as well, although how much time it will buy is questionable.

The U.S economy has been slowing in the last two or three months.  Either downside surprises or actual declines have been reported in key economic indicators relating to consumer spending, new orders, production and employment. A number of major companies have either revised down their second quarter earnings estimates or reduced their guidance for the second half. As a result, second quarter earnings estimates for the S&P 500 have been declining and full-year estimates probably will drop as well.  When we further consider the dysfunction in Congress, the “fiscal cliff”, the prospective end of operation twist, the elections and the prospect of renewed fighting over the debt ceiling, the threats to an already fragile recovery are high.

The Chinese economy is slowing, perhaps by more than the official numbers show.  The NY Times has reported that many local and provincial officials have been falsifying numbers to hide the true extent of the problems.  China’s economic model is heavily dependent on capital investments and exports, while internal consumer spending remains a relatively small part of GDP.  Although Chinese officials recognize the need to increase consumer spending as a percentage of GDP, that is a long-term solution.  In the meantime, exports to Europe, China’s top customer, is falling now and cannot be offset, except by ordering the building of more plants that will produce goods for which there is no current market.  All in all, it seems that it will be difficult to avoid a hard landing.

The slowdown in Europe, the U.S. and China is also impacting the economies of the emerging nations, which are heavily dependent on exports.   Declining growth is also driving down commodity prices.  Despite all of the talk of decoupling, it seems apparent that the economies of all nations are linked and that there is little prospect of an oasis of prosperity in an increasingly dependent world.

Unfortunately, the monetary and fiscal authorities are out of ammunition.  With short-term rates near zero and the 10-year bond yielding 1.6%, there is not much more the Fed can do.  At the same time fiscal stimulus is restrained by debt and deficits that are too high relative to GDP.

In our view, the current situation is reminiscent of the dot-com top in early 2000 and the subprime top in late 2007, when investors remained in denial that the economy was highly vulnerable.  We believe that the April 2nd peak in the S&P 500 marked the top of the uptrend from the March 2009 lows, and that a major market decline is ahead

The Fed’s Shooting Blanks

By Comstock Partners

Yesterday’s significant market decline most likely marks the end of the oversold bounce from the June 4th lows.  The rally was based on little more than the hope of central bank rescues around the world in the face of what has now become a widely recognized global slowdown that threatens the onset of another recession.  In our view the market faces a number of major headwinds including deteriorating economic conditions, a dimmer outlook for corporate earnings, the European solvency crisis and a major slowdown in China and other emerging nations.

While some have called today’s decline a severe over-reaction to a Goldman short recommendation and the sharp drop in the Philadelphia Fed index, the slowdown started becoming evident to us almost three months ago and has been accelerating ever since.  In our comment of March 29th, entitled “The Market Sweet Spot Is Ending”, we noted that, “In just the last two weeks it has been noticeable that expectations have become so high that a number of indicators have started to disappoint”.  Since that time the majority of key economic indicators have continued either to fall short of expectations or show actual declines.  Therefore, the sharp decline in the Philadelphia Fed index reported today, far from being an outlier, is in line with the weight of the evidence that has been developing over the last three months.

In addition to the deteriorating economic conditions, cracks have also started to develop in the corporate earnings picture, which has been the major strong point for the market over the last three years.  We have recently seen either disappointing earnings or lower management guidance for a number of major companies such as Proctor and Gamble, McDonalds, Phillip Morris, Pepsi, Caterpillar, Bed, Bath & Beyond and many others.  The drop in commodity prices along with the slowdown will adversely affect cyclical and energy companies as well.   With earnings season coming up in just a few weeks, it is likely that this will the most disappointing earnings period since the end of the recession. We believe major markdowns in corporate earnings estimates will be a key market feature for the rest of 2012 as well as 2013.

The European sovereign debt crisis will also be a continuing story in the period ahead, and has the potential to be a “Lehman” type situation.  The markets will not give the EU the time it needs for any permanent solution such as full political integration, and anything else will just have the effect of papering things over.  A significant bailout of Spain and Italy will require huge amounts of funds that only Germany can possibly provide, and it is understandable why Germany would be unwilling to place itself in financial and economic jeopardy.

China and the rest of the emerging nations are also slowing down significantly.  While the Chinese government, unlike the Western democracies, can order plants to be built and can force banks to lend, the result would be only more idle plants or factories that produce items that cannot be sold.  The key point is that China and the emerging nations are export-based economies that are highly dependent on Europe and the U.S. to buy their goods.

In the midst of the U.S. economic slowdown, the ability of the Fed to do much more is doubtful.  Despite the Fed’s reduction of its growth estimate and its increase in the unemployment projection, the action it took is minimal and unlikely to help.  As we wrote in last week’s Special Report, “.the easiest and most reliable measures have already been taken and any remaining weapons are unorthodox, untried and subject to unknown negative side effects”.

Chairman Bernanke essentially confirmed this at yesterday’s press conference, when in answer to a reporter’s question, he said, “.the types of unconventional programs that are now available.we know less about them.they have various costs and risks, and for that reason, we might get a different amount of financial accommodation in this kind of regime than one where short-term interest rates can be varied freely”.  He added that a larger Fed balance sheet would be harder to reduce later, could impair markets or foster financial instability.  Although Bernanke did say that the Fed was not out of ammunition, we got the impression that the Fed had done pretty much all it can and that factors such as Europe and the U.S. “fiscal cliff” were beyond the Fed’s control.

In the face of the current economic and financial situation, it is notable that the stock market rally that started in October topped at 1422 (S&P 500) on April 2nd.  After dropping 11%, the subsequent oversold bounce retraced 62% of the decline, and has now turned down once again, re-confirming the downtrend.  In our view the April 2nd peak marked the top of the entire three-year rally dating back to March 2009, and a new cyclical decline has begun.