Kass: A Market on the Brink By Doug Kass RealMoney Silver Contributor 12/17/2007 11:55 AM EST

This blog post originally appeared on RealMoney Silver on Dec. 17 at 8:52 a.m. EST.

"You don't play against opponents; you play against the game of basketball."
-- Bobby Knight, head basketball coach at Texas Tech

In 1986, John Feinstein wrote the bestselling sports book of all time, A Season on the Brink: A Year With Bob Knight and the Indiana Hoosiers, which detailed the audacious and often mercurial coaching techniques of Bobby Knight during the 1985-86 Indiana University basketball season. The season followed an atypical losing season in 1984-85, which was highlighted when Coach Knight, famous for his outbursts, threw a chair across the half-court stripe.

The equity market, similar to the 1986 Indiana University basketball team, is now on the brink, as rising inflationary pressures and slowing economic growth (as confirmed again by numerous economic releases over the past two weeks) have increased the possibility of stagflation -- a condition that has historically led to a contraction in P/E ratios and poor equity returns.

The core of my concerns remains the U.S. housing market (which is why I have spent so much time in the last two and a half years discussing the worrisome mortgage market and its role in a prospective consumer-led slowdown), the future of which is inexorably linked to the current credit bubble's piercing.

Economic bulls have thought that the housing market's problems would be ring-fenced. After all, residential housing activity accounts for only about 6% of GDP -- somewhat less than the 12% to GDP role of business fixed investment, which was responsible for a shallow recession five years ago.

Economic bears, such as myself, focus on the more important role of consumer spending, accounting for a record 71% of GDP, and its likely retrenchment, which is the outgrowth of lower home prices (for the first time since the Great Depression), restrictive mortgage credit and the absence of the home as an ATM for consumption.

Importantly, the days (1995-2006) of relying on the asset appreciation of homes and equities as savings conduits have been reversed.

Since the mid 1980s, the Fed has sanctioned bubble after bubble by stimulating and then ignoring them. Fed members have, up until recently, ignored real inflationary pressures, preferring instead to recognize the artificiality of "core" inflation. As well, the Fed has ignored the causality between the credit market's earthquake and economic growth.

Frankly, it is almost comical to watch "free market capitalists" complain that the Fed did not do enough last Tuesday. From my perch, the Fed is acting responsibly; the critics of monetary policy, on the other hand, are acting irresponsibly by asking for higher and higher concentrations of interest rate opiates.

It is for these reasons (and others) that I have argued that the only hope for our domestic economy is a protracted downturn to break the accumulated economic excesses and the lethal chain of endless asset bubbles of the last two decades.

As I mentioned in my synopsis of my Thursday night appearance on "Kudlow & Company," many talking heads in the media and several economists still have visions of Goldilocks despite what appears to be ample growth and inflationary evidence pointing to the conclusion that we lie at recession's door.

The Goldilocks believers complain of the lack of rigor, or Cassandra-like shouts, of the permabears in predicting slowing growth. The economic polemic is not an argument between the permabulls and permabears, however; it is an argument between reality and fantasy.

Notably, Morgan Stanley (MS) and Merrill Lynch (MER) are now calling for a recession.

Those of us who reside outside of the press box and in the investing field fully recognize that, if indeed the slowdown/recession is soon upon us, by the time the National Bureau of Economic Research, Ben Stein, Don Luskin and Larry Kudlow admit to it, equities will likely be much lower, having discounted the event.

I will touch on only some of the factors that indicate a move toward recessionary conditions.

Growth Concerns

1. The current credit crunch is unlike anything we have seen in modern financial history. The availability of credit will be markedly reduced in the years ahead.
2. Fourth-quarter credit writedowns at the world's major financial institutions remain elevated, and the prospects look no better into early 2008. This permanent loss of shareholders' equity will have negative lending repercussions, and the infusion of high-cost equity at these institutions will do little to encourage the banks to lend more.
3. According to Merrill Lynch, the slope of the yield curve and the value of credit spreads point to a 100% chance of a recession.
4. Last week's trade report indicates that the rate of increase in imports is declining and now stands at the lowest level in over five years.
5. Housing's outlook remains clouded despite the government's patchwork attempt to deal with the reset problems. Publicly held homebuilder cancellation rates are almost 50%, and the inventory of unsold homes is at multidecade levels -- and it's growing, not stabilizing. A 2010 industry recovery could now be in jeopardy.
6. Leading indicators -- such as durable goods and shipping rates (Baltic Dry Index) -- point to a domestic economy that might be moving in a southerly route posthaste.
7. Inventory growth is at a standstill, which is an early warning signal that a drop in business fixed investment is the next shoe to drop.
8. Adjusting last week's retail sales figure for the calendar year and food and gasoline inflation produces a lukewarm picture of retail, despite the permabulls' cheerleading. Same-store comparisons have now been relatively weak for six months, especially at the malls. Target (TGT) ), Sears Holdings (SHLD) and others have recently exhibited disappointing guidance. Just look at a chart of the Retail HOLDRs (RTH) if you need a harbinger of continued poor retail news. Last night, SpendingPulse provided a decidedly weak outlook for apparel sales during this holiday period.
9. Job growth is punk vs. one year, two years or three years ago.
10. A Democratic presidential victory, indicated almost universally by the current polls, means higher corporate and individual tax rates, which will provide an unneeded break on business capital expenditures and personal consumption.

Inflation Concerns

1. Even the greatest works of fiction -- that is, the Bureau of Labor Statistics' chronicling of headline CPI and PPI rates -- are signaling inflation levels not witnessed in several years.
2. Inflation implied in the five-year TIPS market has moved up to close to 2.30%, a gain of 0.15% in only a week.
3. Some Fed governors and former Fed Chairman Greenspan are beginning to look at food and energy price inflation as recurring. (I am still looking for a "core" consumer.)
4. Crude's stubborn rise has resumed as the price of a barrel increased to over $92 last week.
5. The CRB Index rose to within 3% of its all-time high on Friday, as the growth in emerging economies continues to place pressure on commodity prices despite a weakening domestic non-export economy.

Other Concerns

There are other problems to worry about as well, mostly emanating from the last decade of overconsumption (i.e., the lack of due diligence in lending and the disregard of risk in borrowing) and the structured products that permeate the markets today.

• There is no quick monetary or fiscal relief that will fix the deeply rooted credit problems that have translated into assets of mass destruction orbiting within (and sometimes off) the balance sheets of many of our world's financial institutions.
• The largely unregulated derivative markets, the size and variability (read: mortgage ARMs) of consumer debt, the hedge fund (and fund of funds) communities and the world's housing markets grew too fast as common sense and due diligence were abandoned in the last credit cycle.
• Markets are beginning to accept the notion that the financial workout will take time and, in all likelihood, can only be relieved by the natural forces of a protracted recession.
• Technical conditions have deteriorated and seem to be confirming the aforementioned fundamental issues.

Too Volatile to Call

The outgrowth of the aforementioned variables suggests that corporate profit (and profit margin), business spending and personal consumption forecasts remain far too optimistic.

There are some offsets to my fundamental concerns, but they are principally statistical and/or sentiment-based. Most prominent:

• A relatively low trailing market P/E multiple.
• Historically low interest rates.
• Rising acceptance of many of my fears.

It has become increasingly difficult to gain an edge on the short-term market outlook. Quite frankly, anyone who thinks that he has one is lying to himself and to others. The near term is too unpredictable and too volatile and contains too many crosscurrents.

After spectacular successes, Bobby Knight ultimately left Indiana University and ended up coaching the Texas Tech basketball team -- a comedown of major proportions. After years of excellent investment returns, Mr. Market seems likely to follow in the storied coach's footsteps.

I remain more confident than ever in my intermediate view that a period of uneven and disappointing economic and profit growth augurs for substandard stock market returns.

From that context, the market is on the brink.

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At time of publication, Kass and/or his funds were short Morgan Stanley and Merrill Lynch, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.

Read our conflicts and disclosure policy.