Comstock: Debt Deleveraging Process Will Take Many Years

The following is the weekly commentary from Comstock Partners, which makes the point that debt deleveraging is a multi-year event and that we are in the early stages of this deleveraging cycle.

…market reactions are widely out of proportion to the real problems…recent events are a disturbing comment on the power of fear…brave people will make a fortune buying in these days, and then we’ll all wonder what the scare was about.

Right now the U.S. financial markets are trading very much out of fear and not any fundamentals.

The first quote was written by a well-known "expert", and appeared in the Sunday New York Times on August 12, 2007. The S&P 500 had closed that week at 1453 on the way to 666. The second quote is from another "expert" on TV earlier this week. Human beings seem wired to always disbelieve the first move down from a market peak and, invariably, see it as a great buying opportunity. In our view the current fear is well-grounded in fundamentals, and the second observer will be proven to be as wrong as the first.

The current debt crisis cannot be solved by mere declarations from official authorities. The debt crisis began with the decline of the housing market in 2006 and is continuing to this day. Phase I involved the transfer of private debt to sovereign debt by means of massive monetary and fiscal stimulus that has led to statistical economic recovery that remains anemic by historical standards. The problems that emerged with the Dubai crisis heralded the beginning of a sovereign debt crisis and phase ll—the transfer of weak sovereign debt to relatively stronger sovereign debt. The problem is that total debt is not reduced, but keeps getting shifted from weaker to stronger entities. Overall debt is too huge to ever be paid off and the relatively stronger nations will run out of ammunition long before the crisis is resolved.

The only long-term solution is a deleveraging of global debt, a process that cannot be solved with a magic wand waved by central bankers and prime ministers. It is a process that will take many years and will be accompanied by slow growth, numerous recessions and financial turmoil. The weaker European nations are already going on austerity, and there is more to come. Greece will have to undergo severe budget cuts without the benefit of an independent monetary policy or the ability to devalue its currency. Spain is cutting its budget by $18 billion and Italy by $15 billion. The UK, too, had announced major reductions in healthcare, IT and civil service. This will lead to a sharp slowdown or recession in Europe with negative implications for the rest of the world at a time when the U.S. economy is still fragile and China is trying to restrain a major housing boom. The entire globe is in danger of becoming like Japan, which is still struggling after two decades of monetary and fiscal stimulus—and Japan was operating within a global economy was still robust during most of its time of trouble.

In that kind of financial and economic climate it is hard to conclude that the stock market is cheap or that it is oversold on anything other than the very short-term. Most major stock market bottoms have occurred with the S&P 500 selling at 20% or more under its 200-day moving average. The index sold at 28% under its 200-day average at the 2002 bottom and 26% under at the 2009 bottom. Even at the recent lows the market was only 6% under its 200-day average. In addition sentiment is nowhere near as gloomy as it usually gets at major lows. The Investors’ Intelligence Survey show 29% of participants bearish as opposed to 50% or more at most of the past significant bottoms.

Valuation metrics, too, do not indicate that investors are really fearful at current levels with the S&P 500 selling at slightly over 17 times trailing smoothed reported earnings. At major past market bottoms the P/E was below 10. In fact the P/E was below 10 at some point in 17 of the last 60 years going back to 1950. If anything, the current P/E is more indicative of complacency rather than fear. As we have stated many times "it’s all about debt" and the deleveraging process has a long way to go.

  1. Element says

    “Right now the U.S. financial markets are trading very much out of fear and not any fundamentals.”

    … not fundamentals???

    “But we can not sustain this level of deficit financing and debt without losing our influence, without being constrained in the tough decisions we have to make, about, the three ‘Ds’. So, ah, this is a high priority for this Administration, you’ll see it reflected in its national security strategy, and we want to try to begin with the publication of this strategy, to make the national security case about reducing the deficit and getting the debt under control. Recognising that it is going to be very, very politically challenging.” – US Secretary of State Hilary Clinton, Brookings Institute Speech, May 28 2010.

    That’s pretty fundamental and tells me P:E ratios are going to be massively downgraded, as in late 2008, we just don’t know how much yet.

    But yet again, in USA, as in Europe, all fire all hot on deficits and austerity measures (the symptoms) but not a word about a national strategy for eliminating unrepayable debts in zombie banks and mortgage companies who are on public life support and pretending to be ‘profitable’ and ‘recovering’. This is shovelling up the dead pelicans in the wetlands, not killing the busted oil well. That oil is still coming in, it’s just started in fact, and there’s a lot more of it than can be immediately seen via the initial symptoms.

    Where is the ‘top-kill’ for the banking debt-slick that is killing the economic wetlands nursery for small business and employment?

    We need an economic camera at 5000 feet depth to show what the real problem – and real solution – actually is.

    PS: apologies for obvious but very apt metaphor

    1. J. Powers says

      This is it exactly. The reason that Japan’s economy has limped along for so long is (if I understand correctly) precisely that they have yet to sort through their banks and their banks’ balance sheets, killing off the bad ones and saving the good ones. A deluge of QE can cover the symptoms, but it isn’t really a treatment of the cause, let alone a cure.

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