Market Decline Based On More Than Fear:

Comstock Partners, Inc.
May 20, 2010

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Today marked a new phase in investors' understanding of the EU crisis. Although the Euro itself recovered a bit, investors realized that Europe's problems could spread to the U.S. and impede or stop its economic recovery. This would possibly mean that the 14-month market rebound in U.S. stocks may not have been justified. The possibility is more than just a fear, but a realistic assessment of a dire situation. Even if the EU and the Euro survive, all of the member governments, including the relatively stronger ones, would have to undertake severe spending cuts and pay down debt to rectify their budgets. These actions would lead to a long and serious economic slump that would most likely spread across the globe.

The crisis is also reminding investors that we have undergone two 50% plus market declines in the same decade and that the S&P 500 today closed at same level it first reached over 12 years ago in mid-March 1998. The two major declines are a reminder to traders of the benefits of getting out relatively early, while the lack of progress over 12 years make long-term investors wonder what they doing in the market. For those who didn't get out on time at the tops in early 2000 and late 2007, the bell is ringing for a third time.

The potential impact of the European crisis on the American economy and markets is not just Comstock's opinion. In testimony before a Congressional committee yesterday, Fed Governor Daniel Tarullo stated that sovereign debt problems in "peripheral" Europe could spill over and cause problems throughout Europe that, in turn, could be transmitted to global financial markets. This, he said, could cause banks and other financial institutions to pull back on lending as they did following the Lehman bankruptcy. "The result could be another source of risk to the U.S. recovery in an environment of still-fragile balance sheets and considerable slack".

The Fed's minutes of its last meeting, released this week, indicated that the economy was not doing quite as well as advertised, even before the impact of Europe's problems. Attributing the recent increases in consumer spending to temporary factors and a lowered savings rate, they concluded that it was unlikely that consumer spending would be the major factor in driving economic growth. They added that the housing market appeared to have flattened despite major government support and that both sales and starts had stalled at depressed levels. They also saw the possibility of increased foreclosures adding to already bloated inventories of vacant homes, threatening a downside risk to prices. The minutes mentioned that commercial real estate continued to fall as a result of deteriorating fundamentals, while bank lending was declining and credit remained tight.

Other recent economic releases were also not encouraging. The Mortgage Bankers Association (MBA) reported a record 4.63% of mortgages in foreclosure in the first quarter with combined foreclosures and delinquencies amounting to 14% of all mortgages. We note that this is before an expected surge of new defaults and foreclosures as a result of foreclosures being delayed due to attempted workouts and the pending increase of adjustable-rate mortgages due for reset in coming months. In addition applications for new mortgages for home purchases plunged in the week following the expiration of the latest home buyers' tax credit. It was also reported today that initial weekly claims for unemployment insurance unexpectedly jumped to 470,000. While one week doesn't necessarily mean anything, we note that claims have now been flat since year-end, indicating that the labor market still remains weak.

We would be remiss if we didn't mention increasing concern about China as a negative market factor. The Chinese housing market has been booming, and the authorities have been slowly tightening monetary policy. In the first quarter the nation reported its first trade deficit since 2004. If the Chinese economy slows down at the same time that Europe is dealing with its crisis the U.S. and global economy will stall. This is already being reflected in a sudden decline in commodity prices on anticipation of a drop in Chinese purchases. We'll have more on this topic in subsequent comments.

In our view the 14-month rally since March 2009 is over and a major decline is underway. The recent decline has been extreme in the short-term, and some sharp rallies are likely. However, we believe that none of these rallies will hold and that the eventual market bottom will be far lower than today's level.