Kass: No Stock Recovery Without Credit Fix

This blog post originally appeared on RealMoney Silver on March 4 at 8:07 a.m. EST.

This morning (at around 4:30 a.m. EST), the media blamed the abrupt drop in futures on the Intel INTC gross profit margin warning last night (at around 6:30 p.m. EST).

They are wrong.

U.S. stock futures were up most of the evening after the market digested the Intel news. As well, European bourses were well into recovery mode.

That was until Merrill Lynch's Guy Moszkowski ratcheted down his first-quarter 2008 estimate for Citigroup C, from a profit of 55 cents per share to a loss of $1.66 per share. It was only then that all the markets and futures dropped, unnerved by the magnitude of the cut in Citigroup's profit forecast.

Merrill Lynch also slashed Wachovia WB and Bank of America's BAC estimates.

That said, this underscores that the economic debate is now something of a sideshow. Investors should refocus on credit. The real determinant of equity market prices stands on the overburdened shoulders of credit and housing. And as long as credit remains bad (junk bond and credit default spreads), I find it hard to be optimistic that stocks can mount a meaningful rally.

Toward that end, I have repeatedly emphasized the adverse consequences of the long tail of credit. Market bulls, on the other hand, have dwelled on the notion that financial industry writedowns are little more than an accounting issue of artificially marking to market.

They argue that the writeoffs have been exaggerated by the underlying and faulty indices and are not reflective of fundamentals, so the indices' implied default rates will prove, in the fullness of time, to be well above real experience and what is being written down.

I wrote on this subject recently. Though I don't agree with this conclusion, Punk Ziegel's Dick Bove wrote an excellent piece on the topic this week. The "Sunshine Boys" in the media continue to dismiss the credit issue as pie in the sky, almost as a figment of the imagination of the bearish cabal. For example, Trend Macrolytics' Don Luskin, in my last appearance on "Kudlow & Company," accused me of hyperbole when I discussed my expectations for large (and repeated) 2008 financial system credit writedowns. I will continue to take the high road and let the evolving writedowns speak for themselves.

Credit is the lifeblood of economic and financial growth. With the benefit of hindsight, a relatively small group of brokerages and banks (which were already ill-positioned to confront an adverse credit cycle from a reserve standpoint) have poisoned the system with what Warren Buffett described as financial weapons of mass destruction. We now face the potential of a "black swan" event, a possible once-in-a-lifetime unknowable risk tied to a generation of credit and debt excesses as well as a dependency on an unregulated and unwieldy eruption in derivatives.

Meaningfully, the problem is international in scope. For example, yesterday HSBC HBC, which stupidly acquired subprime U.S. lender Household International in 2003, reported that "loans in the fourth quarter were souring at the astonishing rate of $51 million per day." This is not theory; it is reality.

The direction of default rates, delinquencies and foreclosures is unquestionable. Whether it catches up to levels implied by the underlying indices is subject to debate. But based on the credit loss trends (and the market's response to that data), I would rather err on the side of skepticism in these uncertain times.

I continue to be short the money center banks, including Citigroup, Bank of America and JPMorgan Chase JPM. I should have stayed short the brokerage stocks, which stand at the epicenter of the credit crisis.

Doug Kass is the author of The Edge, a blog on RealMoney Silver that features real-time shorting opportunities on the market.