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Bears Still Lurk

Doug Kass

This week, the market has advanced into record territory as market participants' enthusiasm over a noninflationary period of growing and sustained economic growth seems to have improved.

Indeed, since mid-2006, investors have been immersed and have been captivated by a world known as Cramerica, a world in which everything is coming up booyahs, as both good news and bad news are treated as good news.

According to my hedge fund contacts (an admittedly small sampling!), and despite what you may read from others, this week's ramp also resulted in the capitulation by many shorts. The short side has become, for most long/short investors, simply a hedge against profits. And in the competitive hedge fund industry's mandate to create excess returns above the market (alpha), this is rendering the appetite for hedging (read: shorting) increasingly undesirable (to put it mildly).

My Tuesday night debate with Larry Kudlow on CNBC's "Kudlow & Company" pretty much framed the bull/bear argument.

Real GDP growth is currently vigorous (and above expectations), the rate of growth in inflation appears muted, retail spending seemed to be advancing, and, to many, signs of a bottom in housing is at hand.

From my perch (which these days is increasingly taking place on that cold linoleum floor drinking cheap tequila), the dual impact of a mild November and December when coupled with an unusually sharp drop in energy costs has overstated the health of the U.S. economy.

A snapshot of the economy and the uninterrupted rise in the world equity markets is encouraging the notion of a "Goldilocks" scenario. It is supporting a positive investment landscape characterized by narrow credit spreads, record low levels on the major volatility indices, improving investor sentiment and recognition of the benefits of the emergence of new (and emerging markets) and the excessive global liquidity that this development entails.

In looking at the sustained march in equities (13 out of 14 months have recorded positive returns) and the significant records being recorded (consecutive trading days without a 2% or 10% correction), it is clear that we are in a bull market for optimism/momentum and for financial assets (particularly of a long-only kind), while we are in a bear market for skepticism/disbelief and for hedging/short-selling.

My ursine view is focused on the future, not the present. As such, it is less easily defended when equities move upward in an almost uninterrupted manner. It is a prospective and anticipatory view that gives less weight to the seemingly positive recent economic releases and conditions.

It is a contrarian view, because it argues that current trends should not be extrapolated. Rather, my opinion suggests that many of the core arguments that underscore the Goldilocks case will be re-examined over the upcoming weeks and months.

Underlying my fundamental concerns are:

• A tightening labor market (and rising unit labor costs).
• A likely downturn in productivity gains.
• A five-year high in the CRB RIND Index with attendant cost-push inflation implications. (This index measures spot raw-materials prices across a broad group of categories including steel and cooper scrap, tin, zinc, wheat, corn, sugar ... and even lard!)
• The expectation of rising interest rates and cost of capital.
• An implosion in the subprime mortgage market (and a consequent restriction in credit to prospective homebuyers).
• A bubble in credit availability (and private equity).
• The emerging bubble in emerging markets (e.g., over the last six years the India's Sensex has increased by about 300%, while India's total corporate profits have not even doubled -- that's P/E expansion!).
• The levered and vulnerable (long-biased) hedge fund and fund-of-funds (especially of a Swiss kind) industries.
• The broad tax implications of the Democratic tsunami.
• A spent-up American consumer, which should have broad and negative implications for consumer electronics (and the Nasdaq) and a more hawkish Federal Reserve than many expect. (Is anyone concerned about the $100 rally in gold since September 2006, or the quiet 40-basis-point rise in the yield on the 10-year U.S. note?)

To this observer, neither a recession (where my pal Larry Kudlow tries to pigeonhole me!) nor a Goldilocks scenario appears to be in the cards. Rather, I expect a period of lumpy and uneven economic growth in which both investment managers and corporate managers find it hard to navigate.

In time, we will undoubtedly see a mean reversion in home prices, interest rates, credit spreads (and losses), corporate profit margins ... and the world's equity markets.

But for now, it is abundantly clear that the timing of my pessimism couldn't be worse -- as my experience and historical perspective are my albatrosses.

1 What would best describe your stance heading into the coming week of trading? Bullish Bearish Neutral 2 Which of these sectors do you think is set to move up in the coming week? --Choose One--Aerospace and DefenseAirlinesAutomobilesBeverages and Food ProductsBiotechnologyCommercial BanksComputers and PeripheralsConsumer NondurablesEnergy Equipment & ServicesHMOs and HospitalsHomebuildingInsuranceIntegrated OilInternet, Software ServicesInvestment Bankers and BrokersMediaMultiline RetailPharmaceuticalsPrecious MetalsSemis, Semi EquipmentTelecom EquipmentTobacco and AlcoholWireless CommunicationsUtilities 3 Which of these sectors do you think is set to move down in the coming week? --Choose One--Aerospace and DefenseAirlinesAutomobilesBeverages and Food ProductsBiotechnologyCommercial BanksComputers and PeripheralsConsumer NondurablesEnergy Equipment & ServicesHMOs and HospitalsHomebuildingInsuranceIntegrated OilInternet, Software ServicesInvestment Bankers and BrokersMediaMultiline RetailPharmaceuticalsPrecious MetalsSemis, Semi EquipmentTelecom EquipmentTobacco and AlcoholWireless CommunicationsUtilities View the results without voting