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Kass: Near-Term Pros and Cons

Doug Kass

January was a poor month for equities as the dual impact of a continued erosion in credit conditions -- spreads blew out and credit writedowns continued apace -- coupled with a marked deceleration in the rate of economic growth weighed on investors (especially of a Nasdaq-kind). While the Fed responded on Wednesday to the above issues by aggressively shaving the fed funds rate by 125 basis points, market participants have, thus far, generally greeted the move with a Bronx cheer.

Positives:

• Speculation and market excesses, typically associated with important market tops, are nonexistent in almost any asset class -- perhaps apart from the 2006 to 2007 price action in Google (GOOG), Research In Motion (RIMM), Apple (AAPL), Baidu (BIDU) and the Chinese market.
• P/E multiples are low relative to interest rates.
• The appetite for risk has turned lower, and a healthy and more responsible period of lending and borrowing will follow.
• TED spreads and Libor have trended lower.
• The curative process of shoring the world's financial institutions, abetted by the new dominant investors (i.e., sovereign wealth funds), is moving at a rapid pace.
• The ne'er-do-wells at leading brokerage and banking institutions who presided over the reckless accumulation of "non-earning" assets are gone, and they have been replaced by more responsible executives who are refocusing on core competencies.
• Hedge funds have historically low net long invested positions.
• The Fed has reduced interest rates and appears to be committed to moving further over the short term; rate-sensitive corporate balance sheets will be the beneficiary as the cost of capital subsides.
• Corporate balance sheets (and liquidity) remain strong.
• Sovereign wealth funds (sitting on $7 trillion) remain a source of liquidity and a capital supplier to impaired financial institutions.
• Private equity's long lockups and base of uncommitted capital, over time, could become another source of market liquidity.
• Arguably, domestic GDP growth still remains statistically healthy.
• Emerging market economies continue to be strong.
• According to RealClearPolitics, the Democratic Tsunami of 2006 appears to be losing some steam, and, with it, the politics of trade protectionism might founder and an extension of the Republican tax policy could be in the offing.
• Based on a dour media, bearish investor surveys, high put/call indicators, oversold oscillators and stochastic readings, a stock market negativity bubble has emerged.
• A SocGen market bottom, similar to the duct tape market bottom at the beginning of the Iraq invasion, might have been put in place last Wednesday.

• Market participants have lost confidence in the policy decisions made by the Fed (monetary), the Treasury (fiscal, especially of a mortgage-kind) and in the Executive Branch (domestic and foreign).
• The Fed might be pushing on a string.
• Monetary policy works with a lag, and the economic outlook for the first half of 2008 is worsening.
• The prospects for stagflation are rising.
• The derivative market remains unwieldy and unregulated (and outside the realm of traditional banking capital regulations), and the financial books remain cooked and difficult to evaluate.
• Emerging market growth is contributing to demand pull inflation, even as the U.S. economy falters.
• Credit default swaps and junk bond spreads remain elevated.
• Hedge funds (and the fund of funds that are their lifeblood) have been roughed up in January and are adding to daily market volatility, and those funds have proven to be little in the way of a hedge.
• The private mortgage companies that insure and the financial institutions that finance the housing markets remain impaired and unwilling (or unable) to provide credit.
• The prospects for a housing recovery remain far off.
• The consumer lacks confidence and remains levered and spent-up, and the outlook for personal consumption expenditures has deteriorated.
• The rate of job growth will likely continue to disappoint.
• Forecasts for 2008 to 2010 corporate profit growth (and margins) remain too optimistic.
• The outlook for business fixed investment is muted and is deteriorating.
• The stock market's technical moorings are poor and remain weak, despite the rally of the last week.
• While the Republican party appears to be gaining traction, a lot can happen between now and November.

One of the key questions I have not addressed in today's opening missive is, To what degree have my expectations of a 2008 recession been already discounted in the U.S. stock market?

Typical bear markets that precede economic downturns drop by approximately 20% and last between six to 12 months. If we are in a typical cycle, a similar move down of 20% would produce about a 1,250 S&P 500 target, but a great many stocks appear to have already discounted a 1,250 price level last Wednesday, at the SocGen market bottom, when the S&P 500 breached the 1,280 level.

Unfortunately, we won't have the answer until after the fact.

What I do feel strongly about is that looking out into the intermediate term, the workout of many of the negatives (especially of a credit-kind) will take time and, importantly, will likely contribute to an inconsistent and lumpy economic and market backdrop that will be difficult to navigate for both corporate managers and investment managers.

A period of substandard investment returns remains my baseline assumption for 2008 to 2010. In such a setting, keeping below-average investment and trading positions seems to be a reasonable strategy in order to take advantage of a volatile market backdrop and an uneven performing domestic economy.

Pick stocks not markets.