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Kass: The Downside

This commentary originally appeared on Real Money Pro on Dec. 12 at 8:18 a.m. EST.

In last Monday's column, I proposed the possibility of an uber rosy scenario -- a set of potentially more positive developments in U.S. politics, in the trajectory of domestic economic growth and in Europe's attempt to contain the debt crisis that could have a salutary impact on business, consumer and investor confidence. I opined that these factors could conspire to create a surprisingly good backdrop for the U.S. stock market in the period ahead.

Today we will consider the shorter-term challenges and headwinds to that uber rosy scenario.

Some have already emerged; others might emerge in the months ahead and disappoint markets.

By means of background, what we do know for sure is that there are continued risks associated with the impact of the current balance-sheet retrenchment and the challenges of numerous secular and structural headwinds could weigh like an albatross around the neck of economic growth. The end result is that the world's economic recovery remains imperfect and likely experiences only moderate growth relative to previous recoveries. There is little margin of safety concurrent with continued threat and a higher probability of tail risk.

Offsetting the above is that most now understand and have acknowledged these risks.

As a result, stocks are reasonably priced -- particularly as measured against any valuation model that incorporates the current low level of interest rates and contained inflation and inflationary expectations.

As I have written, there are four conditions that I thought would make or break the U.S. stock market:

  1. the market's volatility would need to subside;
  2. the sharp division in Washington, D.C., must turn to compromise;
  3. forceful policy in the eurozone was necessary to stem the debt crisis; and
  4. we wanted to see a stability/improvement in the hard domestic economic data, which would negate the possibility of an economic downturn or double-dip.

Of late, the only condition moving in the right direction is the pace of growth in the U.S. economy. The others are, arguably, getting no better or are worsening. (Reflecting these influences, stocks were stalemated in November and, thus far, in December.) These short-term challenges and risks are currently corrupting the adoption of an uber rosy market scenario.

Heightened Volatility

The binary outcomes of a stock market without memory from day to day have continued, as reflected in the daily fluctuations of risk-on/risk-off. As a result, retail investor outflows (from domestic equity funds) continue uninterrupted, as investor confidence further erodes against a backdrop of limited market visibility in an uncertain and unpredictable world.

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