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25 Takes on 2007 Surprises, Part 1

James Altucher

I have to say again that Doug Kass is bold for putting out his 25 Surprises for 2007, parts 1 and 2. All I can do is comment on them rather than go out on a limb like he did. I do think his stab at attaining "prophet" status is both thought-provoking and a little "did he really say that?" but his ideas are great jumping-off points worth following up on.

Here are my thoughts on his 25 -- and I look forward to any email or Columnist Conversation responses they provoke.

1. Private equity deals. Kass gets into specifics about the private-equity transactions he believes will happen in the beginning of the year, including ones with Kohlberg Kravis Roberts, Goldman Sachs(GS Quote) and Berkshire Hathaway(BRK.A Quote).

I agree with his general sentiment, that 2007 is going to be the year of private equity. There is so much cash out there, it's ridiculous, and the shameful secret every private-equity firm carries is that its management fees begin to go away if it doesn't spend the money. They're all time bombs of massive leveraged buyouts waiting to happen.

Doug's specific call that Goldman is going to go private definitely won't happen, though, particularly with Warren Buffett behind it.

2. Citigroup changes. I found this item very stimulating: Kass says that Bob Rubin, former Goldman Sachs chief and Treasury secretary under President Clinton, will become CEO of Salomon Brothers if ("when," as Kass says) Citi decides to spin it off.

I believe there's zero chance of this, but with so many people calling for Chuck Prince's head, I wouldn't be surprised to see Rubin, currently Citi's chairman, become CEO as well.

3. Stabilizing housing. Kass says: "Based on misleading government statistics, the housing market appears to stabilize in the first quarter of 2007." With interest rates so low and prices in many areas already plunging, why wouldn't the housing market stabilize? I agree with his conclusions, but without the conspiracy theory.

4. "The Great Housing Depression of 2007." I just don't see it, not with 4.5% rates on 10-year yields and short-term interest rates getting cut at any sign of a more severe downturn in housing. Although, that said, I do somewhat agree with No. 5.

5. "Foreclosures steadily rise." I do believe that the subprime, BBB-rated category of homeowners is in trouble. These are people who have never been granted loans before and now they're getting mortgages at almost the same rate a herd of Bob Rubins would get them. However, these also are exactly the sort of people who don't have a huge effect on the economy one way or the other when they abandon their homes.

Kass says that the asset-backed securities, or ABS, market will be fractured by the volume of foreclosures at the subprime level. I've spent some time doing due diligence on very smart funds on both sides of this trade. I have no idea who is right(Nobel-level economists were doing the modeling on each side, so who am I to argue?). However, if the ABS market does start to fracture, enough hedge funds and banks are short the subprime tranche that a short squeeze would buffer any fall.

6. and 7. The hedge fund and derivatives industries. These are scary "surprises" worth pondering. If the subprime market falls apart, banks such as JPMorgan Chase(JPM Quote) could be exposed to trillions of dollars in counterparty risk. This is a doomsday scenario, and I know at least one multibillion-dollar hedge fund that told me it has taken out credit insurance on JPMorgan as a bet that this actually will happen. But there's a reason this type of insurance trades for pennies on the dollar: Most people believe this doomsday scenario is extremely unlikely. I'm in that camp.

8. Commodities. Kass says they'll collapse, and I agree that commodities will go down like they always do. Check out my column on the Madagascar Vanilla market to learn why.

9. Flat corporate profits. I just don't see how this is possible, given the extreme dollars that are going to be spewing at Microsoft(MSFT Quote) because of Vista and Exxon Mobil(XOM Quote) because oil is nonstop, and Google(GOOG Quote) because online advertising is going up another $6 billion and it'll be the main beneficiary -- just to name a few.

But this is a hard thing to model out with precision, and almost everyone I spoke to at the beginning of 2006 (you know who you are) was wrong about where we would be now in terms of corporate earnings.

10. Volatility rises exponentially. This one really interests me because the reality is, volatility confuses me. It's usually measured by the VIX indicator. In the 10 years I've been trading, the VIX has never been even remotely as low as it has been this year. And right now, this second, it's basically at an all-time low, or near it:

VIX Swings Low It hasn't been this low in a decade

Historically, this has been a mean-reverting indicator; in other words, when the VIX very high when compared with historical averages, it invariably comes down (as in 2001 and 2002) and when it's very low, it invariably goes higher. Very roughly, without going through the math on this, the VIX being at 10 right now means investors are assuming the markets are going to be almost flat over the next year with a very tiny range throughout the year.

This is almost certainly false; I agree with Kass that volatility will go up. We could even experience massive corrections along the way, since an increase in the VIX is usually associated with a decline in the market.

However, the VIX is so low that I don't know if we can really use any historical results to make a prediction here. After all, the markets and the VIX rose in tandem from 1995-99. And now more than ever before, hedge funds that use put-selling strategies have flooded billions into how this indicator is calculated, artificially lowering it. The VIX could go up, but I don't necessarily know if this will cause panic in the markets.

11. The arc of the markets. Kass believes the markets will begin 2007 very strong. I agree. But then he predicts that the S&P will end the year around 1250, dropping 11% in 2007.

Certainly a correction can happen. But the global economy right now is flourishing; interest rates are low, continuing to have their stimulus effect; and price-to-earnings ratios relative to interest rates are near all-time lows. Historically, the earnings yield of the S&P 500 (earnings over price; about 6% projected for 2007) has almost always been lower than the yields on T-bills. Now it's greater. The market is pretty much backing in almost permanent zero or less growth in the economy. I believe that when people realize this is not happening, the S&P 500 will spike incredibly in 2007.

In particular, Kass believes tech will fall by 20% in 2007. Didn't this already happen just a few years ago? Again, short-term corrections can happen. But Vista is going to light things on fire at some point in 2007.

12. Fidelity and Alliance announce dedicated short products. I'm sure this is top of mind for Kass because his product is a hedge fund-dedicated short product. But Doug, don't worry so much. Try to enjoy life a little!

13. M&A activity will begin to slow down. With private-equity firms flush with cash and S&P 500 companies sitting on $600 billion in cash, I just don't see this happening.

Editor's note: Check back for Part 2 of this column Monday.