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Kass: Get Real and Drop the Rosy Forecasts

This blog post originally appeared on RealMoney Silver on Nov. 19 at 8:07 a.m. EST.

With the exception of a few holdouts -- such as Ben Stein, Sir Larry Kudlow and FT Advisors' Brian Wesbury -- there is finally recognition by most economic observers and market participants that if the economy isn't currently in a recession, it is likely entering one shortly.

I believe there is little doubt that the body of (growing) economic evidence will force the few remaining economic permabulls to tweak their spreadsheets, allowing for reality by year-end. (Well, maybe not Ben Stein!)

Meanwhile, those opaque financial institutions around the world, under the pressure of FASB157 and their investors, are finally 'fessing up to how badly they played the credit cycle and how their shortage of common sense contributed to a gluttonous investing behavior in which they believed their own nonsense in packaging and selling dubious securitizations and "ate their own cooking."

Since I have been gone, the last few weeks have signaled a weakening domestic U.S. economy:

  • Retail sales have soured -- even category killer Starbucks (SBUX) experienced negative comps.
  • Industrial production has turned down.
  • Credit conditions have worsened -- the triple-A portion of the four-month-old ABX Index has dropped by over 20%, to about 72.0, in the last three weeks; the double-A portion has declined over 40%, to about 40.0.
  • Housing activity continued its death spiral.
  • Signs of corporate profit margin contraction are plentiful, most recently by FedEx (FDX) late last week.
  • Investment firms' subprime writedowns have quickened, and money market funds have made their own confessions.
  • And, reflecting the changing economic reality, the equity market is souring while the bond market is sparkling.

The first step to the restoration of value in the stock market is recognition of the credit problem.

The good news is that the credit participants and the markets are finally starting to get their hands around the problems. The bad news is that it might still be early in that process as the U.S. economy "matures." No doubt, the Bobbsey Twins of Unconscious Credit Creation, Merrill Lynch (MER) and Citigroup (C), will scare the dickens out of the markets with outsized and additional writedowns in the fourth quarter of 2007.

More significant is that the transformation from credit abundance and a general disregard for what tomorrow might hold has quickly morphed into the panicky recognition that tomorrow is here. Investors are finally recognizing the important role that excess credit/debt generation had on the last decade's economic prosperity and how the de-accumulation of credit will contribute to the downside over the next two to three years.

But what remains worrisome is that expectations for corporate profit growth are still elevated, and markets will likely remain vulnerable until the expectations for 2008 earnings growth become more realistic.

To make matters worse, the conspicuous trading presence of the quant funds -- those model-driven and former fund-of-funds' faves -- will complicate the picture by pressing weakness and strength in the market and in individual securities (regardless of fundamentals!). As well, redemptions in those quant funds, other hedge fund strategies and in the fund-of-funds community (which have been the lifeblood of hedge fund industry growth) are almost certain to complicate and confuse price action over the balance of the year.

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.

At time of publication, Kass and/or his funds were short MER and C, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.

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