COMSTOCK PARTNERS UPDATE

A Secular Bear MarketApril 21, 2005

Despite today’s strong rally it is likely that the 29-month cyclical bull market peaked at 1229 (S&P 500) on March 7. Since that time the index dropped 7.6% and gained back 2% today. At the close it still was at about the same level as last November 4, just two days after the U.S. presidential election. The recent March 7 top was still a whopping 21% below the all-time high of 1553 in March 2000, confirming our belief that we are currently in a secular bear market. Rallies in bear markets develop from oversold conditions and are often quite explosive, but generally peter out well below previous highs.

The bull market was based on an economic recovery spurred by two major tax cuts and massive ease by the Fed that used soaring asset values, primarily in residential real estate, to support consumer cash flow in the absence of normal growth in employment and wage income that usually provides the support for economic expansion. The result is record consumer debt, historically low consumer savings rates, a massive trade deficit and big federal budget deficits. The highly stimulative policy avoided the immediate negative consequences of a bursting financial and economic bubble, but only at the cost of exacerbating these structural imbalances that will prove difficult to resolve without a major crisis.

The stimulative effects have now faded, and instead we are faced with a tightening Fed monetary policy and soaring energy prices that are likely to work against economic growth in the period ahead. In last week’s comment we outlined how the economic softening has already begun to show up across a broad cross-section of indicators.

Make no mistake about it--pay attention to what the Fed does rather than what it says. In our view entirely too much attention is paid to examining the minutiae of the FOMC statements, which, under the guise of so-called transparency, are geared toward influencing markets and softening the harsher aspects of the real actions. For instance, in the most recent FOMC statement (March 22) you will see that the equality of upside and downside risk now depends on appropriate monetary policy (a new caveat). But obviously, since they can never say that their monetary policy is inappropriate, the risks must always be equal as long as this caveat remains in the statement.

In addition, after using the “measured” word they say that they will nevertheless respond to needed changes. Therefore they can increase the funds rate by 25 points, 50 points, or not at all and still be “measured”. Although the FOMC is correct in not wanting to restrict its future choices, what, then, is the purpose of the statement other than briefly stating their action on rates? It certainly doesn’t result in greater transparency, and the new policy of releasing the minutes three weeks later muddies the waters even more. Therefore ignore the shell game, and just be aware that we have undergone seven straight rate increases, and that, historically, a tightening monetary policy has preceded bear markets and recessions in the vast majority of cases. Combined with extremely high energy prices, the prospects this time become even more problematic.