Kass: Fear Makes a Comeback

Though the market's price momentum (the voting machine) is horrible, valuations (the weighing machine) are compelling, representing the classic conflict between the trader and the investor.

It is important to recognize that, notwithstanding the yearlong rally from March 2009, stocks have been stagnant for years. (The S&P 500 is now back to levels seen in late 2001.) So, as an asset class, stocks were never stretched to the degree of other asset classes -- commodities, private equity, residential and nonresidential real estate were all lifted to multiple-sigma events.

I do try to remain realistic and recognize many of the reasons for the lack of progress in equities in nearly a decade. As I wrote in "The Decline and Fall of P/E Multiples," some discount from historic ratios seems appropriate given the reality of the current and prospective cycle. Most notably, taxes are rising, fiscal imbalances are large and unprecedented, there is an absence of drivers to replace the prior cycle's strength in residential and nonresidential construction, the tail of the last credit cycle remains long during the current deleveraging environment, and we have remarkably inept and partisan politics.

These factors, now increasingly accepted by many, will serve to cap the upside of equities but not preclude a healthy advance, as, with an 8.8% earnings yield against a 2.95% return on the 10-year U.S. note, the corporate profits/interest rate differential is among the widest in decades. (The same favorable comparison applies to stocks vis-a-vis investment-grade bonds.) In other words, the U.S. stock market's P/E multiple of 11.5 times compares quite favorably with a U.S. bond market's P/E multiple of over 33 times.

Interest rate indicators are mixed in terms of their growth message. Though the absolute level of treasury and investment-grade yields indicate less than 1% real growth, the Fed's own model indicates less than a 5% chance of recession, and the shape of the yield curve points to continued growth.

My baseline expectation is that, despite the hyperbolic dire market warnings and the admittedly poor price action in the markets around the world, the domestic economy is simply decelerating from a V-shaped recovery toward moderate expansion.

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