Kass: Grading My Surprises So Far

This blog post originally appeared on RealMoney Silver on March 31 at 8:31 a.m. EDT.

"Never make predictions, especially about the future."

-- Casey Stengel

At today's close, we will conclude 2008's first quarter, so it's time to begin evaluating my surprise list for 2008.

In late December/early January of the past five years, I have taken a page from former Morgan Stanley strategist Byron Wien (now the chief investment strategist at Pequot Capital Management) and prepared a list of possible surprises for the coming year.

The real purpose of this endeavor is to consider positioning a portion of my portfolio in accordance with outlier events -- with the potential for large payoffs. After all, Wall Street research is still very much conventional and "groupthink," despite the reforms over the past several years.

Mainstream and consensus expectations are just that, and, in most cases, they are deeply imbedded into today's stock prices. If I succeed in at least making you think about outlier events, then the exercise has been worthwhile.

Last year's (2007) surprise list was our most accurate ever. It wasn't the quantity of the correctly predicted surprises that made 2007's list a remarkable success; it was the quality, as I hit on nearly every major variant theme -- the severity of the housing depression, the turmoil and writedowns in the credit markets, the curtailing of private equity deals and the reawakening of equity market volatility.

The 2008 list could prove even more prescient -- and, importantly, could have saved investors quite a bit of money (especially by avoiding the finance sector). With one quarter of the year now over, here are my grades for my surprises for 2008:

1. The Housing Depression of 2007 morphs into the Retail Spending Depression of 2008. Stubbornly high inflation coupled with a deceleration in the rate of job growth, which turns into job losses by midyear, and an absence of innovation (a creativity void in consumer electronic products and apparel), leads to an unprecedented and abrupt drop in personal consumption expenditures.

The Retail HOLDRs (RTH Quote) exchange-traded fund declines to $80 from $94. Despite their apparent "value" today, retail stocks, especially women's apparel, are among the worst-performing stocks in the first half of 2008.

Grade B+: The Retail HOLDRs declined a swift $10 during the first two weeks of January and has recently rallied back to about $90. More importantly, the evidence suggests that the housing problem has clearly begun to affect personal consumption and retail stocks have been among the worst-performing market sectors to date.

2. Under pressure from slowing consumer spending, disappointing capital spending and higher commodities, corporate profits drop by 10% in 2008. Importantly, the pattern of economic activity grows increasingly inconsistent and lumpy, providing a difficult backdrop for corporate managers and investment managers to navigate.

Grade B+: During the last few months, corporate profit forecasts have been cut in the face of slowing retail sales, reduced capital spending expectations and higher input costs.

3. The S&P 500 falls by 5 to 10% in 2008, and 2007's laggards and leaders continue to be the same laggards and leaders in the coming year.

Grade A: The S&P has dropped by approximately 10% this year.

4. With a continuation of the credit and liquidity crises and an increased recognition that financial retrenchment will take years (not months), volatility pushes even higher. Daily moves of 1% to 2% become more commonplace, serving to further alienate the individual investor.

Grade A: Volatility has been the recurring theme of 2008.

5. The Federal Reserve embarks upon a series of moves to ease monetary policy in 2008. Nearly every meeting is accompanied by a 25-basis-point decrease in the federal funds rat,e even despite continued inflationary pressures.

Nevertheless, the economy fails to revive as the Fed pushes on a string.

Grade B+: While the Federal Reserve has been more aggressive than I expected, its impact has been disappointing to most observers. Inflation remains elevated.

6. Growth in the Western European economies deteriorates throughout the year, and the markets in England and France drop at twice the rate of the U.S. market.

Grade A: The European markets have fallen more swiftly than the U.S. stock market, and their economies have as well.

7. The Chinese juggernaut continues apace, and, despite continued protestations of a market bubble, the Chinese market doubles again in 2008.

Grade F: Rising inflation, growth fears and a general weakness in emerging markets have crippled the Chinese markets.

8. The Japanese market puts on a surprising resurgence as the world's investors respond to compressed valuations (vis-à-vis peer regions), reasonable multiples (absolutely and against Japanese bond yields), accelerated M&A activity, share buybacks and relative strong corporate profit growth.

Grade C+: The Japanese market has fallen at half the rate of the U.S. stock market.

9. The administration's proposal to revive the housing market falls on its face (as the housing bust accelerates), and President Bush enlists a well-placed Democrat and former cabinet member to become the U.S. housing czar, who has the primary charge to propose and administer a massive Marshall Plan for housing.

Several high-profile housing-related bankruptcies occur in 2008, including Countrywide Financial (CFC Quote), Beazer Homes (BZH Quote), Hovnanian (HOV Quote), Standard Pacific (SPF Quote), WCI Communities (WCI Quote) and Radian Group (RDN Quote).

Grade B: While there were no bankruptcies, there were several bailouts. The housing initiatives have been unsuccessful.

10. Financial stocks fail to recover. No financial company is immune to the eroding market conditions, the spike in market volatility, the uneven direction in commodities and currency prices. Even the leader of the pack, Goldman Sachs (GS Quote), makes several bad bets in the derivative, currency and commodity markets, and its shares begin to underperform its peers as profit forecasts move lower.

Citigroup (C Quote) halves its dividend, and the shares briefly trade in the mid-$20s. Asset sales and writedowns leave the bank crippled, and in late 2008 (after another capital infusion by Abu Dhabi), Citi is merged with Bank of America (BAC Quote). Its new name is its old name: CitiBank!

Bear Stearns (BSC Quote) is acquired by HSBC (HBC Quote) in a take-under (well below today's price) -- as investor Joe Lewis loses nearly $350 million on his near-10% position in the brokerage firm.

Mutual fund outflows and uncertainty regarding the integrity of money market funds result in the asset-management stocks being among the worst-performing sectors in 2008. With private-equity deals at a standstill, Blackstone (BX Quote) shares trade down close to $10 a share. Late in the year, CEO Stephen Schwarzman and his management group take the company private.

Grade A: On every account, this surprise was extremely accurate. Goldman Sachs appears to have slipped up; Citicorp markedly reduced its dividend (and its shares are languishing in the low $20s); Bear Stearns was acquired in a take-under, but by JPMorgan Chase (JPM Quote), not HSBC; mutual fund outflows continue apace; and Blackstone's shares are at $15.