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Kass: The Return of the Animal Spirits

This blog post originally appeared on RealMoney Silver on Aug. 5 at 7:36 a.m. EDT.

Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits -- a spontaneous urge to action rather than inaction -- and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

-- John Maynard Keynes
A critical aspect of animal spirits is trust, an emotional state that dismisses doubts about others. And the move from about 1,020 to 1,130 in the S&P 500 over the past five weeks has reignited investors' animal spirits. Indeed, many of the skeptics of early July have been transformed into raging bulls, as it usually is among those who worship at the altar of price momentum.
"When the facts change, I change my mind. What do you do, sir?"

-- John Maynard Keynes
But, have the facts really changed?

While I continue to believe that the July 1 lows will not be revisited in the months ahead, as the hyperbole surrounding a double-dip in the domestic economy has abated, along with steady improvement in certain risk markets (e.g., junk bond yields down, euro up, industrial commodities higher, two-year swaps down), the facts (i.e., the fundamentals) have not changed much.

The sharp ramp up in the indices has been surrounded by the continued ambiguity of the economic soft patch, which grows daily and was reinforced with this week's sluggish data -- factory orders, pending home sales, personal income and spending were all weak. Moreover, recent economic releases now point to a revision of second-quarter GDP to under 2% later this month.

And with the structural increase in unemployment, the economic outlook for the second half of 2010 still looks less than certain, especially relative to the magnitude of the market's rise and to the rise in animal spirits that has accompanied it.
"The man who is a pessimist before 48 knows too much; if he is an optimist after it, he knows too little."

-- Mark Twain
I am 61 years old!

My baseline expectations for a subpar economic expansion and a range-bound market remain unchanged. I continue to look for a relatively narrow range in the S&P 500 of between 1,025 and 1,150 over the balance of the year. As we are now moving toward the higher end of the projected range, I plan to de-risk, and, should the domestic economy deteriorate further, I can see moving back into a net short position.

Intermediate term, I continue to expect a period of inconsistent and uneven economic growth that will be difficult for corporate managers (who do not have pricing power and face tepid top-line growth) and investment managers to navigate. With an elevated unemployment rate, the economy will feel worse than it is. In the quarters ahead, there will be times when it will appear as though we are reentering a recession; at other times, it will appear that we are reentering an expansionary phase.

From my perch, lumpy growth and the emergence of nontraditional headwinds (fiscal imbalances at the federal, state and local levels, higher marginal tax rates, a costly and burdensome regulatory backdrop, etc.) will serve to cap the market's upside valuations and target level within a few percentage points from the current level.

To conclude, on stocks and bonds, consider me at the polar opposite of Mae West, who once exclaimed, "I only like two types of men, domestic and imported."

Doug Kass writes daily for RealMoney Silver , a premium bundle service from For a free trial to RealMoney Silver and exclusive access to Mr. Kass's daily trading diary, please click here.
Doug Kass is the general partner Seabreeze Partners Long/Short LP and Seabreeze Partners Long/Short Offshore LP. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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