Some Surprises in Store for 2005

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Editor's Note: This Doug Kass column is a special bonus for RealMoney readers. It appeared on Street Insight on Dec. 6. To sign up for Street Insight, please click here.

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It's that time of the year again!

Borrowing an idea created by Morgan Stanley's Byron Wien, every December I prepare a list of 25 possible surprises for the following year.

My surprises are not intended to be predictions, but rather are intended to represent events that might have a reasonable chance of occurring despite the general perception of these events carrying very long odds. I call these "possible improbable" events.

I have long felt that developing a variant view (read: surprise) remains an integral part of differentiating one's investment returns. Mainstream and consensus expectations are just that, and, in most cases, are deeply imbedded in today's stock prices.

The real purpose of this endeavor is to consider positioning a portion of my portfolio in some part based on outlier events -- with large potential payoffs. After all, Wall Street research is still very much convention and groupthink, despite the reforms over the past several years. If I succeed in making you think about outlier events, the exercise has been successful.

I hope some of my surprises helped in framing investment themes during the year. Many of my surprises were on target last year; to be precise, almost one-half of the "possible improbables" came true, up from only one-third of my 2003 surprises coming to fruition.

In particular, the following actual events had a familiar ring for readers of my 2004 surprises.

The No. 1 and most audacious forecast -- that of a crude oil price of more than $50 a barrel -- was realized.
My interest forecast was spot-on (and equally audacious, at the time). I called for a bottoming-out in the 10-year yield at 3.20% when most were looking for an increase in interest rates (we were only a few basis points away) and a year-end yield close to the same levels of December 2003.
The emergence of calm in Iraq, an absence of domestic terrorist incidents, still-low interest rates and an increase in merger and acquisitions activity contributed to a marked improvement in equities during the second half of the year. (It was an improvement, albeit far from our surprise of a 30% increase from the May lows and a 15% improvement year over year.)
Merger activity accelerated, with, as expected, a plethora of bank stock deals leading the way.
The automobile industry's fortunes declined dramatically.
Despite widespread belief that housing activity would fall off the cliff, my expectation of a further rise in home prices, which began to resemble the bubble in the Nasdaq in the late 1990s, was realized.
The IPO and secondary markets launched a meaningful comeback during the second half of the year.
Calls for stricter hedge fund legislation made strong inroads.
A unified Democratic party rallied behind Sen. John Kerry, who won the party's presidential nomination.
Questionable accounting practices at Freddie Mac (FRE - commentary - Cramer's Take) led to more restrictive rules governing derivative accounting.
The New York Stock Exchange, in a stunning reversal, made plans to go fully electronic.
There were no terrorist acts in the U.S.

Possible Surprises in 2005

1. After a lackluster holiday retail season, the consumption binge of the last decade comes to an abrupt halt. Retail sales turn negative and home prices plummet (first on the east and west coasts, then in the rest of the country) while (cost-push) inflation accelerates. The minipanic of 2005 occurs -- during a two-day period the stock market drops by 9% -- as stagflation concerns surface.

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At time of publication, Kass and/or his funds were long Dow Jones, although holdings can change at any time.

Doug Kass is general partner for three investment partnerships, Circle T Market Neutral L.P., Seabreeze Partners L.P. and Kass Partners LLC. Until 1996, he was senior portfolio manager at Omega Advisors, a $4 billion investment partnership. Before that he was executive senior vice president and director of institutional equities of First Albany Corporation and JW Charles/CSG. He also was a general partner of Glickenhaus & Co., and held various positions with Putnam Management and Kidder, Peabody. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Kass appreciates your feedback and invites you to send it to [e-mail].