Comstock "Case For A Market Top"

The chances that the market is in a major topping process are rising significantly. History indicates that major bottoms occur when valuations are low, monetary policy is easing, and sentiment is extremely negative. The subsequent uptrend is then confirmed by a change in trend from down to up. At peaks the opposite is the case. At that time valuations are high, monetary policy is tightening, and sentiment is highly bullish. The next downtrend is then confirmed by a change in the trend from up to down. In our view the evidence indicates that we are on the verge of resuming the secular bear market that began in early 2000. Let’s briefly review each of these factors.

VALUATION—The S&P 500 is selling at 20 times trailing reported earnings. Over the past 78 years the average P/E ratio has been 15.8, even including the recent outlying years. For most of these 78 years the range between high and low has been about 21 times to 7 times earnings. Markets selling at the high end of the range have resulted in below average subsequent returns or outright declines, while markets selling at the low end have been followed by higher than average returns. The analysis holds true under other metrics as well, including the dividend yield, the price-to-sales ratio, the price-to-cash flow ratio, and the price-to-book ratio. Most observers try to get around this analysis by using a forward price-to-earnings ratio and inflating earnings by excluding so-called one-time occurrences (called operating earnings). If we do this, however, the average historical P/E ratio is more like 10 or 11, still leaving the market highly overvalued. Comparing P/Es using forward-looking operating earnings to historical P/Es using trailing reported earnings is akin to comparing apples and oranges.

MONETARY POLICY—History indicates that tightening monetary policy is poison for the stock market. The Fed has now raised short-term interest rates six times, and says that the rate still must move higher to be consistent with their policy of neutrality. The three-steps-and-stumble rule, promulgated by the late Edson Gould, states that whenever the rate is raised three consecutive times, the market goes down. This rule has been highly accurate for the last 75 years, and with good reason—and it has proved to just as valid when interest rates were low as when they were high. The key is direction rather than absolute levels. These tightening periods usually lead to economic recessions as well since the Fed doesn’t stop tightening until something negative happens, and that is not good for stocks.

SENTIMENT—Market sentiment is always high at peaks. Currently, the Investor’s Intelligence Survey shows 54% of all market letter writers are bullish, while only 21% are bearish. Historically, these observers have been 50-to-60% bullish and 20-to30% bearish at tops. In addition cash as a percentage of assets in equity mutual funds is only 4.1%, close to a 39-year low. At market bottoms the cash percentage usually runs into double digits. The VIX measure of volatility is near an eight-year low. This indicator is usually low at market peaks and high at bottoms.

TREND—So far the upward trend since early 2003 has not been broken, although the narrow trading range in force since mid-November may be a warning that the uptrend is faltering. Since that time the S&P 500 has fluctuated between 1217 and 1163. In the last secular bear market from 1966 to 1982, the rallies following presidential elections have tended to peter out between mid-December and mid-January. To date the market peak of 1217 on January 3 is right on schedule. Given the high valuations, bullish sentiment and tightening monetary combined with the probability that this is a secular bear market, a significant break below 1163 (which we think is a strong possibility) should lead to far lower levels and a test of the 2002 bottom