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.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.


Comstock Partners, Inc. analyzes economic and financial conditions from a long-term macro-economic perspective and makes adjustments based on cyclical and shorter-term considerations. In pursuit of its goals, the firm invests in various asset classes including domestic and foreign stocks, bonds, currencies and derivatives including indices and options

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  • Andrew P

    The only assumption that is probably true is #2. There will be noise and minor political uncertainty, but Treasury payments will come on time and Federal spending won’t be cut too much in any case. There might even be huge increases in spending if more States join Arizona and accept the expansion of Medicaid.

  • perpetual neophyte

    1. Straw man. I don’t think any reasonable person believes “markets can’t go down.” They may believe that liquidity trumps fundamentals, except in a broad panic sell-off. They may also believe that they – like Comstock – cannot predict the timing of such panic sell-offs. Therefore, they may decide that an overweight to equities is better than being in cash or 100% Treasuries over some intermediate to long term.

    2. What is “substantial market damage?” It sounds like they are assuming some binary scenario where someone is all in on equities right now. You can assume the sequester and debt ceiling debates get resolved with “minimal” market and economic damage relative to the longer term and still have some cash ready to “buy the dips” should headlines drive a panic sell-off.

    3. What if earnings look more like $100?

    4. GDP growth and equity returns need not be directly connected. Who says you can’t have years of below-trend (but positive) GDP growth and still have positive market returns?

  • Johnny Evers

    5. The market might go down 10 percent, but if it does it will bounce right back.
    6. The market might go down 25 percent, but if it does I will have anticipated this and moved my money before it does. I am watching things very carefull and if I see signs that the market is going to fall I will get out of the way before it does.

  • James

    All well and good, but why do we need it? I’m not sure whether we as citizens of August to pay, and yet we should look mainly account.

  • hangemhi

    There are two really odd comments in this piece – the 2nd to last paragraph reads like it was written 2 to 4 years ago “we are now in a period where consumers will be pairing down debt…”. And the other that Fed policy hasn’t worked. HELLO – debt levels are down, and now real estate is on the rise again. It took several years to see the benefits of low rates – and now that we are this article ignores the news?

    Am I the only one who sees surprises to the upside coming? At least short term?

  • inDC

    The problem with your upside is it is dependent on a Fed which keeps printing. We are rapidly approaching the point where we will find out which contains the greater pain: a Fed that never stops printing, or a Fed that does stop. Unfortunately, I am going to be alive to see this horrible experiment come to its conclusion.

  • Tom Brown


    Do you know what the current private debt to GDP ratio is? This chart too is perhaps a little dated, but it’s hard to believe we’d be down at a healthy level (like we were right at the end of WWII in 1945). Based on the trend line in this plot recently, it looks like we’ve got about another decade or so of private sector deleveraging yet to go:

    The peak there in 2008/2009 was truly amazing! We weren’t even nearly that high even after all the ponzi borrowing of the 1920s!

  • Tom Brown

    The Fed “printing” doesn’t do much to bring private debt levels down. Some perhaps… some people can refinance their homes.

  • Geoff

    Hangman, you are not the only one who believes that there is a good chance that any surprise will be to the upside. A real estate rebound leading to a releveraging of the household sector and in turn the corporate sector could easily be in the cards. If so, this year could be spectacular.