The Best of Kass

Taking the Road Less Traveled
Originally published on Sept. 2 at 8:02 a.m. EDT.

Two roads diverged in a wood, and I--
I took the one less traveled by,
And that has made all the difference.

-- Robert Frost, "The Road Not Taken"

Bull markets are born out of distress -- witness March 2009. Bear Markets are born out of prosperity -- witness 2007.

Liquidating/de-risking out of equities and acquiring/re-risking into fixed income has been the mantra of most individual and institutional investors over the course of the last three years. Since early 2008, retail investors have sold over $200 billion of domestic equity funds, while purchasing nearly $600 billion in fixed-income products. That gap of over $800 billion is unprecedented as is last decade's spread in performance of bonds vs. stocks the largest in history. But history tells us that the S&P 500 performs famously in the following decade and ultimately moves contra to a peak in flows.

I continue to believe, as expressed recently in "The Scale Tips to the Bullish Side," that it has once again become time to take the road less traveled and to raise net long exposure at precisely the time when such a strategy is most unpopular. (I took another road less traveled over the past few days, as I ventured from East Hampton, N.Y., to Northwestern University in Evanston, Ill., with my son in a 1,100-mile adventure in "Bessy," our U-Haul.)

In many ways, the sentiment toward equities today is as bad as the extreme experienced at the generational low 18 months ago. Indeed, at Tuesday's close, the market zeitgeist was eerily reminiscent of 1979 in which BusinessWeek published its "Death of Equities" cover.

Frankly, it was that bad. And if you don't believe me, just peruse some of Jim "El Capitan" Cramer's downbeat and gut-wrenching columns on RealMoolah prior to yesterday's ramp. His verbiage quite accurately described the dour sentiment permeating the hedge fund community.

Mr. Market simply got to Jim, in the same manner it got to many others. He wrote about it while most felt it.

The fact is that most classes of investors now view U.S. stocks with distrust.

And, as I have previously asked, who is left to sell, especially if the concerns regarding a double-dip prove unjustified?

I continue to view the double-dippers as on the wrong page. There are multiple reasons for this view.

Consider that the cyclical components of GDP, such as autos and housing, now contribute so little to aggregate GDP that the year-over-year impact in late 2010/early 2011 can only modestly impact output. Moreover, with inventories-to-sales so low and with auto and residential investments so far from their longer-term trendline relationship to GDP -- ergo, demand is pent-up! -- a double-dip seems an unlikely event. Even the spent-up consumer's debt-service ratio is at its lowest level since 2000, and, owing to a generational low in mortgage rates, a refi boom is inuring further to the consumers' state.

Certainly, Wednesday's economic releases over here and over there (in China) confirm my baseline expectation that growth is moderating but not likely to decline.

Souring sentiment, reasonable valuations, an absence of inflation, the likelihood that monetary policy will remain easy and the unlikelihood of a double-dip continue to form the foundation of value-creation in equities.

In the fullness of time, there is almost an inevitability that a large reallocation trade out of bonds and into stocks is forming. If I am correct, many investors are now offside.

In summary and from my perch, 10-year Treasuries yielding under 2.60% seem dear and should be shorted while U.S. stocks trading at 12x reasonable 2011 S&P profits seem cheap and should be purchased.

Make no mistake -- the road less traveled will continue to have bumps, and some of those potholes will be with us for some time:

• The securitization market and the shadow banking industry are shattered and shuttered and will no longer deliver credit anywhere to the degree they did in the last credit cycle.
• Residential and non-residential construction will not serve as a driver to growth, and there is little to replace the void.
• Regulation will remain a costly burden on industry.
• It is increasingly obvious that there is a structural increase in unemployment in the decade of the temporary worker.
• A policy of populism geared against the wealthy and large corporations will have negative implications -- higher marginal tax rates will weigh on growth/profitability.
• Fiscal imbalances at local, state and federal levels are unprecedented.

The good news is that most of these nontraditional headwinds -- it's different this time! -- are now recognized by most investors, so the vehicles traversing those bumpy roads seem to be reasonably prepared and relatively well-equipped.

Tactically, I would be patient, and I would not chase yesterday's strength. The journey may well prove worthwhile over the balance of the year.

Looking further ahead, the lost decade has passed us, and a new decade is upon us.

Re-risk ... prudently.

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