Kass: Why the Market Doesn't Rally

This blog post originally appeared on RealMoney Silver on June 26 at 7:39 a.m. EDT.

The FOMC statement, suggesting that the Federal Reserve is in no hurry to tighten, led to a rally in all maturities along the Treasury yield curve as the U.S. dollar dropped modestly. But U.S. equities disappointed again yesterday -- and they're not looking so hot today.

Under most conditions, the diminishing risk of a too hawkish Federal Reserve should have elicited a more salutary response. But this is not your father's stock market!

The problems seem to be that the consensus view of a short-lived and painless domestic recession is losing its credibility and that expectations for a turnaround in corporate profit growth in the last half of 2008 and early 2009 are being dashed (bears would be more dramatic -- they would say that expectations are that we are now or soon will be crashing down).

On the first score, it is increasingly clear that the average historical average duration of a recession of 10 to 11 months will have little application to the current period, as there appear limited areas of economic contribution to replace the consumer's constructive role over the past decade. The massive worldwide cyclical delevering of debt/credit, a levered and inflation-pressured consumer (whose principal assets -- housing and stocks -- and income statements are all deflating), a continued collapse in residential real estate and an equity-deficient financial system (leading to less credit availability and more expensive cost of borrowings as balance sheets are repaired) continue to suggest that the downturn of 2008-2010 will be unique in its pain -- and that a more protracted period of substandard growth/weakness lies ahead.

As to corporate profit expectations, Dow Chemical's (DOW) announcement on Tuesday (it will raise product prices by as much as 25% -- after a similar announcement only a month earlier -- institute freight surcharges and cut output because of soaring energy prices) was a wakeup call that optimism on profits is too high and that a mean regression of profit margins seems likely. And after the market closed, higher-than-expected inventories at Nike (NKE) and weak guidance at Oracle (ORCL) and Research In Motion (RIMM) (two well positioned and well regarded companies) confirmed a deteriorating 2008-2009 profit outlook.

We are left with the issue of whether the equity market has discounted the inevitability of lower profits.

And that's a tough one.

I have argued that S&P profits will come in at about $10 a share under the 2008 S&P consensus forecast of earnings of $90, but still, stocks have more than discounted an $80 earnings result.

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