Comstock Partners 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.
Looking back at the long history of the U.S. stock market it is clear that there are long periods when the trend is distinctly up or down. We call these long trend “secular” markets as opposed to the commonly-known cyclical market trends that last about four years on average. In our view we are currently in a secular bear market that began when the market peaked over 11 years ago in early 2000.
The most powerful secular bull market took place in the 18-year period from 1982 to 2000. In this period the market rose from 777 on the DJIA to almost 12,000 (16% compounded/year); the S&P 500 from about 100 to 1550 (16% compounded/year); and the NASDAQ from about 160 to 5050 (22% compounded/year). Although there were two other powerful secular bull markets such as the periods from 1921 to 1929 and 1949 to 1966, the bull market of 1982 to 2000 was the most significant by far.
The last half-decade of the 1982-2000 advance was accompanied by arguably the most spectacular financial mania of all time. Stocks, most often in the technology sector, typically went public and tripled on the first day of trading. The so-called dot.com stocks often had no earnings while others were merely concepts that didn’t even have revenues. To justify the ridiculous prices of these stocks, analysts came up with new and untried metrics such as the number of eye balls that were viewing or would be viewing their websites rather than fundamentals such as earnings or cash flow.
Starting in the late 1990s Comstock constantly warned clients how sick the mania had become. We did this through lengthy bi-monthly reports in print and later through brief comments on our website. Although we were too early, our judgment was finally vindicated for all of the right reasons once the stock market finally peaked in early 2000. At that time we were convinced that the market was entering a secular bear market that would last for many years. The combination of the extremely powerful 1982-2000 bull market accompanied by a senseless financial mania was the recipe for the start of the secular bear market we envisioned.
You would have to think this secular bear market would be extremely severe with the combination of a major bull market followed by a financial mania. The market did decline by about 50% but the powers that be did whatever possible to delay or reverse the secular bear. Fed Chairman Greenspan tried to stop the severe stock market decline by lowering the Fed Funds rate to 1% in mid 2003 and keeping it at that level for a year. This move stopped the bear market in its tracks. The low rate enabled home prices to accelerate to the upside, and congress jumped in to help the Fed with the rescue by passing every law they could to make it easy for virtually anyone to buy a home.
This started the housing market on a tear (or bubble) since anyone who wanted to buy a home was able to do so by putting up little, or no money. Many of these loans were called “no doc” loans which meant that there was no documentation (like annual salary) required in order to get the mortgages approved. This caused a housing mania that was exacerbated when investment banks packaged the loans and sold them to their clients. They wound up selling packages of very poor quality mortgages (sub-prime) called “collateralized debt obligations” (CDOs) and convinced the rating agencies (who were paid by Wall Street) to rate these “securitized mortgages” AAA. To make things worse, most of the brokerage firms that understood the toxicity of these CDOs protected themselves by buying “credit default swaps”, which were paid off when the loans defaulted.
Now, if the most significant bull market in U.S. history, that drove the stock market to “nose bleed” levels, followed by a dot com financial mania wasn’t enough to start the secular bear market, what would? Well the market did drop by about 50% in 2000-2003 and was on its way to completing the secular bear. But, when the Fed induced a housing market mania accompanied by a cyclical bull market in stocks (within a secular bear) you would think that when the secular bear resumed it would be more severe and deeper. So far, it did produce another 50% decline in the stock market in 2008 and early 2009 as a credit crisis in 2007 caused the worst recession since the Great Depression.
The major 50% decline in the market also fit the same path as Japan as one of our “special reports” discussed in 12/2/2010 “Is America Following the Same Path as Japan?” Japan “hit the wall” after experiencing a similar stock market move from 1972 when the Nikkei 225 was trading about 2000 until the end of 1989 when it reached over 39,000 (18% compounded/year). If you recall it was in the late 1980s when everyone believed that Japan would take over all the manufacturing in the world. At one time the U.S. had a robust TV industry until Japan essentially took over the industry and made virtually every U.S. TV in the late 1980s. This move up in Japan was driven by excesses in the non-financial corporate debt side. That was when Japan corporations bought Pebble Beach and Rockefeller Center and anything else that was for sale. Japan paid the price for the excess debt- driven bull market that drove the Nikkei to almost 40,000 and now is under 10,000 over two decades later.
The key 18 year bull market we experienced here in the U.S. ending in 2000 was driven by excesses in household debt. Although wage growth had flattened out, consumers wanted a larger home, a nicer car, and nicer clothes whether they could afford it or not. If they ran out of money with their credit cards and bank loans they would take out a second mortgage on their homes that they felt could never decline in value. Household savings rates, which usually averaged about 9%, fell to near zero. Household debt as a percentage of GDP generally averaged about 50% of GDP and 65% of personal disposable income (PDI). However, starting in the early 1980s (as the stock market started this amazing bull market run discussed earlier) household debt rose to 100% of GDP and 130% of PDI by 2008.
Once the secular bear market started in 2000 we were convinced that the U.S. public had learned their lesson and would start to pay down their debt and begin saving again. We were wrong. After Greenspan lowered rates and started another financial mania driven by home values and the stock market, we were again convinced that the public couldn’t be fooled again. However, after enormous bailouts of the largest financial institutions in the country, as well as the auto industry, and even more monetary ease than in 2003 (accompanied by TARP, the stimulus plan, QE, and QE2); we started another cyclical bull market within the secular bear market. The stock market went from severely oversold in March of 2009 to gaining 100% from those levels. We are convinced that, after the latest 100% rally since March of 2009, that this was the last time the public could be fooled again. And this time we are able to determine that consumers are saving more and consuming less; we believe this change in attitude will continue for a long period of time, creating severe headwinds against strong economic growth.
The most important question to ask yourself is, “can we have another major bull market in U.S. stocks anytime in the near future?” We believe the answer is a resounding “NO”! Just look at what took place in Japan after their stock market and economy “hit the wall” at the end of 1989. The private sector corporate debt that was primarily responsible for the most significant bull market in Japan’s history continued deleveraging for decades. Government debt rose in order to replace the shrinking of the non-financial corporate debt (the debt that drove their bull market) that was either defaulted on or paid off. If the non financial corporate debt drove the market up during their great bull market, it only makes sense that their stock market (Nikkei 225) would decline as the deleveraging process was taking place. And that is exactly what has been taking place for the past 21 years (since 1989) as the Nikkei declined from almost 40,000 to under 10,000 where it is presently. We also note that during the past two decades Japan’s GDP grew at an average annual rate of only 1%.
Why would we expect any different outcome in the United States as the household debt sector (the main sector that rose and drove the U.S. bull market of the 80s and 90s and also continued adding to the debt as the housing market took off from 2003 to 2007) is still in the process of deleveraging since 2007? That is just a little over 4 years, and we can expect a continuation of deleveraging for many years to come-we have a long way to go in order to get back to the levels of household debt relative to GDP or Personal Disposable Income (PDI). (See attached charts)
The U.S. stock market will not be able to rise in a sustained manner if we are correct in believing that U.S. households will continue deleveraging for the next few years to as many as 10 more years. The key is that household debt will have to decline to the levels of the 1950s, 1960s, and 1970s of 50% of GDP and 65% of PDI. That would mean the weak consumption will continue and that should lead to disappointing economic growth. The average annual growth in consumption over the last 50 years was about 3.5%, but only 0.6% over the seven quarters since the recovery started. That is the lowest growth rate since the Great Depression.
So the next question is, “How will the deleveraging affect the economy? And how will a weak economy affect corporate earnings? ” If the deleveraging affects the U.S. economy the way Japan’s deleveraging affected their economy over the past 21 years, it will clearly be highly negative for U.S economic growth. Since GDP growth and profits are positively correlated over time, that should negatively affect corporate earnings that have driven the stock market up for the past couple of years.
Now that operating earnings estimates for the S&P 500 have risen to the record levels of $100 again, we suspect that the deleveraging and weak economy will affect this estimate in a similar vein as in 2008, when S&P 500 earnings estimates were over $108 as late as May of that year. Actual earnings came in at less than $50 for operating earnings and less than $15 for “reported” earnings.
The bottom line is that we expect U.S. stocks to stay in the secular bear market that started in 2000 for many years to come. We believe the main factor that drove the most significant bull market in U.S. stock market history (household debt that enabled unrestricted consumption of everything from goods and services to homes) will reverse and continue the deleveraging process that will more than likely continue for a very long time. This deleveraging will act to affect the stock market in the exact opposite manner as the leveraging did in the bull market. To quantify this, if we were to look at historical household debt relative to GDP and DPI we would expect the debt to be in the area of about $7 to $7.5 trillion. Instead this debt rose to about $14.5 trillion at the peak in 2008 before declining to about $13.5 trillion presently. We expect this debt to fall below $10 trillion. This could take many years and be very painful for our economy, corporate profits, and the stock market.
click for PDF graphics
Standard and Poors 500
Dow Jones Industrial Average
Household Debt Percent Personal Income
Personal Consumption Expenditures as % of Disposable Personal Income
Performance of Real PCE vs. 1991, 2001 and Avg of Last Six Expansions
Economy (Index of Coincident Economic Indicators) – Revised
Why We Believe we are in a Secular Bear Market
Comestock Special Report, June 16, 2011