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Some Surprises in Store for 2005

Doug Kass

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 Quote - Cramer on FRE - Stock Picks) 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.

2. U.S. equity prices drop by double-digit percentages in the first half of 2005 and, unlike 2004, show no recovery after the initial drop for the balance of the year.

3. The Japanese Nikkei is among the best-performing equity markets in the world; the London market is among the worst-performing equity markets.

4. In the face of a precipitous drop in the U.S. dollar (with the euro briefly trading at 1.55!), the Federal Reserve drops its gradualist approach to monetary policy. Taking a tune from the Fed's moves in May and November 1994, the Fed tightens by 50 basis points and then by 75 basis points on two consecutive Fed meetings.

5. The year 2005 brings another large-scale, Long-Term Capital-like failure precipitated by an astonishingly large derivative loss that three major U.S. and overseas money center banks are partially on the hook for.

6. Europe sinks into a recession in the second quarter. The U.S. sinks into a recession in the fourth quarter.

7. After a brief move back above $50 a barrel, crude oil trades back to less than $30 a barrel as demand slackens in the face of a worldwide economic slump.

8. There are no major terrorist acts in the U.S. However, England becomes the target of a surprise contamination of that country's water supply by al Qaeda. Equity markets in England are closed for a 10-day period and the price of agricultural commodities rises dramatically (reminiscent of 2004's rise in the price of crude oil).

9. The Bush administration imposes a national sales tax in an unsuccessful attempt to balance the budget. In the face of a worldwide downturn, the tax is repealed within six months.

10. Warren Buffett raises Berkshire Hathaway's(BRK.A Quote - Cramer on BRK.A - Stock Picks) stake in Coca-Cola(KO Quote - Cramer on KO - Stock Picks) to 13% by purchasing in a private transaction all 122 million shares owned by SunTrust(STI Quote - Cramer on STI - Stock Picks). Berkshire Hathaway goes on a buying spree as equities tumble. Berkshire acquires Dow Jones(DJ Quote - Cramer on DJ - Stock Picks) at $58.50 a share and two troubled, publicly held reinsurers.

11. Citigroup's(C Quote - Cramer on C - Stock Picks) Bob Rubin takes over the reins at AIG(AIG Quote - Cramer on AIG - Stock Picks) from Hank Greenberg, who retires.

12. The junk bond market records its worst performance in more than a decade and underperforms almost every asset class in 2005.

13. The gold market records the best performance of any asset class in 2005, briefly touching $575 an ounce.

14. Housing stocks make nominal new highs as interest rates decline, but a series of order disappointments and guidedowns for 2006 make this sector among the worst-performing areas of the U.S. equity market as the inventory of unsold homes rises parabolically.

15. A sub-prime lender or sub-prime insurer fails.

16. A computer hacker generates a serious virus that infects a large portion of the Internet. This causes a problem for several weeks at Amazon(AMZN Quote - Cramer on AMZN - Stock Picks), Google(GOOG Quote - Cramer on GOOG - Stock Picks), eBay(EBAY Quote - Cramer on EBAY - Stock Picks), Yahoo!(YHOO Quote - Cramer on YHOO - Stock Picks), AOL and many other sites.

17. Democratic aspirant Al Gore re-emerges on the political scene. New York Sen. Hillary Clinton announces her intention not to enter the 2008 presidential race. Both former President Clinton and Chelsea Clinton announce their candidacies for political offices. Late in the year, Tom Ridge announces his intention to seek the Republican nomination for the 2008 presidential election.

18. Time Warner(TWX Quote - Cramer on TWX - Stock Picks) sells its AOL division to Marc Cuban in a leveraged buyout after the company settles Securities and Exchange Commission and Justice Department charges and as subscriber defections moderate.

19. AOL founder Steve Case re-emerges on the corporate scene as the CEO of an Internet startup that goes public and records the largest percentage rise in history of any initial public offering on its first day of trading.

20. Tyco(TYC Quote - Cramer on TYC - Stock Picks) embarks on a series of high-profile acquisitions.

21. The SEC's experiment in eliminating the downtick rule is abandoned coincidently with the double-digit decline in stock prices during the first half of 2005.

22. There is a major accounting irregularity (spring-loading earnings) uncovered in a highly regarded industrial conglomerate famous for its acquisitive appetite. Larry Summers leaves his post as president of Harvard University and becomes chairman of this troubled company.

23. Sumner Redstone gives Howard Stern permission to leave Infinity Radio earlier than his contractual responsibility and Sirius Satellite Radio(SIRI Quote - Cramer on SIRI - Stock Picks) briefly trades at $10 a share. However, subscription levels at Sirius fail to reach expectations and the stock halves.

24. HMOs become the new focus of New York Attorney General Eliot Spitzer.

25. The New York Jets win the Super Bowl, the University of Illinois wins the NCAA Basketball Tournament and the New York Yankees capture the World Series. Pete Rose is elected to the Baseball Hall of Fame and Barry Bonds is barred from baseball for steroid use.