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Kass: The Hardest Stock Market to Navigate Ever?

Doug Kass

Yesterday's opening missive -- Get Real and Drop the Rose Forecasts -- delivered a familiar refrain: Stay cautious and trade/invest small with volatility on the rise.

It is for these reasons that I have suggested that opportunistic trading/investing (i.e., buying the dips and selling the rips) and lower-than-usual positions are strategies that can deliver excess returns in an increasingly volatile market.

During the middle of the day, I suggested that Fed-cut rumors should be flying:

I fully expect rumors that the Fed will cut before the December meeting will emerge now.

And we closed the day with another familiar message for a market without memory from day to day:

The market is getting schmeissed, but the VIX is flat. That was the positive market tell last week as well. So the seeds might be sowed for another tradeable rally. Stay tuned.

Monday's market had more moves than a shortstop batting .110, and, right on cue, CNBC and other media outlets are reporting this morning of the emergence of rumors that the Federal Reserve will announce a rate cut after an emergency meeting.

Similarly on cue, the futures suggest that the market might gap higher on the opening -- my admiration for the PowerShares QQQ(QQQQ Quote) and the N's over S's (Nasdaq over the S&P) remains intact -- a possible contrarian development I offered, even despite the awful close and even worse price action.

To me, even despite the profound weakness, the late-day stability in the VIX signaled some promise, and our notion of a market without a memory has temporarily continued to prove prescient.

Arguably, this is the hardest market to navigate in years, and this is manifested in the likely closure of some sizable hedge funds. Those liquidations might be contributing to the recent spate of selling.

Case in point: brilliant hedge fund manager Ed Lampert, whose canvas of Sears Holdings(SHLD Quote), AutoNation(AN Quote), AutoZone(AZO Quote), Citigroup(C Quote) and others looks worse than Sotheby's recent weak auction of Impressionist paintings.

Up until recently, the permabulls got lucky as the fumes of credit/debt creation gave a false picture of economic health and belied a weakening technical stock market foundation. Most of the fundamental optimism that supported their bullish views has turned out to be incorrect, while the technical moorings that many of them depend upon have deteriorated as well.

Away from the short term, where volatility will be rampant and opportunities to buy and short will abound, the permabulls -- similar to the permabears of yesteryear -- continue to be "in hope" and ignore the message of these two disciplines.

Do not pay attention to their utterings of continued sound economic growth and positive technical/sentiment signals, and, above all, give up on the notion of a negativity bubble, as stocks don't collapse the way they have recently when shrouded with pessimism.

Above all, be independent in your analysis and practical in your trading and investing. In the current environment -- whether buying or shorting -- err on the side of conservatism.

My preferred strategy in times of excessive volatility is to buy the dips and sell the rips. It is not for everyone. But, as Jim "El Capitan" Cramer preached last night on "Mad Money," buy and hold is not likely to be as profitable as it has been in the past. With commission rates and capital gains tax rates historically modest, a more flexible trading approach (long and short) will contribute to superior returns. And, as Jim counsels, homework is always the ticket.

I have my own set of views; weigh them against some of the more positive (and rigorous) constructs, and make your own decisions.

I immersed myself in the fundamental risks a month ago in "A Brave New Investment World":

The next five years in the capital markets seem destined to be unlike the last five years. The most significant difference is that the egregious use, generation and packaging of debt will not be repeated -- and the consequences of that leverage will be adversely seen in areas of the world economies that we had never contemplated.

From my perch, the bulls continue to think very linearly and seem to be missing how significant the role of credit was to past growth and how significant a pullback in credit will be on future growth. Significantly, the markets continue to underestimate the consequences of leverage and are overestimating the prospects for corporate profit growth.

But that they're taking place at the same time doesn't mean they're otherwise equal. As Doug Kass, the redoubtable bear who runs Seabreeze Partners, points out, the bullish part of this hybrid bull-bear market has been restricted pretty much to a relative handful of high-steppers (a number of which, as it happens, are prominent components of the Dow and the S&P 500 averages). Since Doug views everything through some expensive designer glasses darkly, he points to historic instances as demonstrating that narrow bull markets end badly.

In support of his forebodings, he cites the Nasdaq 100's spectacular performance so far this year -- last we checked, it had shot up a cool 25%, or some 448 points -- as a startling illustration of how a few exceptionally strong stocks can give the impression of a big bull move. Of that roughly 25%, or nearly 450 points, gained by the Nasdaq 100, a whopping 230 points, or over half the index's rise, has come from just three issues: Apple(AAPL Quote) (135 points), Research In Motion(RIMM Quote) (60 points) and Google(GOOG Quote) (35 points).

No accident that each of that triumphant trio is part of the big, amorphous sector dubbed 'tech'. For, according to that perceptive observer referred to a few paragraphs above, the torrent of dough exiting the financial shares, which for so many years ruled the investment roost but lately have been feeling the effects of the credit chill, has flowed in gobs into techs, which has been largely out of favor for quite a spell.

No accident, either, he says, that Apple, Research In Motion and Google wear the growth label. For, he believes, the long dominance of value over growth in investor preference is in the process of changing, and, if and when the market regains its footing, growth will reassert its preeminence. The emphasis, though, will not be on current momentum favorites like Apple, Research In Motion and Google, but, instead, on that vast legion of growth stocks that have conspicuously lagged in markets ever since the dot-com bust.

By persuasion, our man is a technician, and as accomplished a practitioner of that mysterious art as ever studied a chart. He thinks there's still room on the downside here, noting there remains a mess of excesses, and he's also concerned that emerging markets, including those he's well-disposed toward, are 'overly extended,' or, to translate from the jargon, too pricey.

He feels the market will bottom temporarily next month and get a lift, temporary as well, from the usual year-end boosts. As to next year, leaning on the workings of the so-called presidential cycle, which translates usually into decent stock performances in the last two years of a president's term, he expects a middling stock market, neither especially weak nor notably strong. But comes 2009, he cautions, then possibly comes, too, the reemergence of the bear market, and it could be a big, bad one.