Comstock Partners: investors are in a state of denial, ignoring all of the bad news that is certainly no secret, Looks like 2000/2007 Part Deux

The spread between the percentage bullish

and the percentage bearish soared to 41.6,

the widest since October 2007,

when the market peaked.

Comstock Partners, Inc.
April 7, 2011

In both late 1999 and 2007 we warned against the mentality that caused investors to overlook the dire-looking events that were swirling all around them. The warnings were generally ignored on the grounds that you couldn't fight against a market that was continually rising. Of course, we now know the eventual outcome. Once again the market is rising despite a spate of negative factors that are widely known to the investing public. The main bullish theme is that the economic numbers are improving, corporate earnings are robust and the Fed will guarantee this will continue even if it has to institute QE3 and QE4. Unfortunately, however, a number of factors are indicating that the good fortune is about to end soon. We cite the following.

1. QE2 is ending on June 30th. The program will, by that time, have pumped $600 billion into the economy, meeting Chairman Bernanke's stated goal of jump-starting the stock market. The end of the program means a defacto tightening of monetary policy. This has been the major factor holding up both the stock market and a fragile economy that will not be self-sustaining once the Treasury bond purchases are halted. A continuation of quantitative easing is highly unlikely as it would be politically difficult. Furthermore an increasing number of FOMC members are themselves hinting at a possible imminent tightening.
2. Fiscal policy is about to tighten as well. That is obviously what the discussion in Washington is all about. Whether the government temporarily shuts down or not is a non-issue. The fact is that, one way or another, both sides of the debate are now intent on reducing the federal deficit. So, whatever the merits, both fiscal and monetary policy will be less easy. That is a headwind against the economy and stock market
3. A broad array of commodity prices is rising. This is increasing corporate costs at a time when they will be difficult to pass on as consumers are strapped for income and are paying down debt. This is bound to squeeze profit margins in the period ahead and result in downward earnings guidance.
4. The Mid-East turmoil is continuing and showing no signs of slowing down. Although the eventual outcome is unknown, it is doubtful that it will be market-friendly.
5. The European Union (EU) is another major problem. First the authorities tried to build a firewall around Greece, second around Ireland, and now around Portugal. These are relatively small economies, and the EU can probably "kick the can down the road" one more time with no real solution in sight. Now they are attempting to build a wall protecting Spain, a nation said to be "too big to fail and too big to rescue". If Spain follows the lead of Greece, Ireland and Portugal, the results could be catastrophic to the global financial system. In the midst of these events the EU has also raised interest rates, a move they last made in the summer of 2008 just prior to the credit crisis.
6. China is battling against soaring inflation and has increased interest rates four times in the last five months in an attempt to slow down the economy. No financial bubble has ever been stopped without a recession, and we doubt that this will be the first. This would have major ramifications on the global economy including the commodities markets, emerging market suppliers, multinational corporations and the U.S bond market.
7. The Japanese earthquake is yet another headwind to the economy. Toyota is shutting down all of its American factories, and American vehicle manufactures are facing parts shortages as well. According to AutoNation, "production disruptions will significantly impact product availability from Japanese auto manufacturers in the second and third quarters." We're hearing about supply disruptions in a number of other industries as well. We won't be surprised to hear numerous companies comment on this issue when they report first quarter earnings and give guidance for the rest of the year.

All in all, we see the tailwinds that have helped the economy and markets over the past year suddenly turning into headwinds. We expect to see downward revisions in both economic growth and corporate earnings in the period ahead. At the same time, according to "Investors' Intelligence" , the bears seem to have thrown in the towel as the percentage of bears dropped to 15.7%, the lowest since December 1999. The spread between the percentage bullish and the percentage bearish soared to 41.6, the widest since October 2007, when the market peaked. Just as in early 2000 and late 2007, investors are in a state of denial, ignoring all of the bad news that is certainly no secret. Comstock Partners Bios