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Kass: What to Own and How Much

Assuming my baseline economic and profit expectations remain intact, my preferred batting style is to wait for the right pitch now, and I would expect to be raising my long exposure during any short term market price weakness.

"He who lives by the crystal ball soon learns to eat ground glass."

-- Edgar R. Fiedler, "The Three R's of Economic Forecasting -- Irrational, Irrelevant and Irreverent"

My starting point when I construct my portfolio and determine exposures is always valuation.

I fully recognize that modeling an S&P 500 price target implies a degree of precision in an imprecise world. More often than not, markets overshoot, both to the upside and downside. Nevertheless, while our exercise and process are not intended to be an exact science, this sort of methodology eliminates emotion and has historically added value as an investment discipline.

Updated Fair Market Value Calculation for the S&P 500

Below is an updated view of the criteria I use to evaluate the S&P 500 and for which I conclude that fair market value is approximately 1345 (almost exactly the price level of Friday's close).

Scenario No. 1 (probability 25%): The pace of U.S. economic recovery reaccelerates to slightly above-consensus forecasts (3%-plus real GDP) based on pro-growth fiscal policies geared toward generating job growth; corporate profit margins being preserved (with low inflation and contained wage growth); interest rates remaining low; and housing recovering sharply, owing to the adoption of aggressive plans by the government to enact a massive home refinancing effort and deplete the excess inventory of unsold homes. Europe stabilizes (and experiences only a shallow recession), and China has a soft landing. S&P 500 profit estimates for 2012 are raised modestly to $106 to $110 per share. Stocks, valued at 14.5x under this outcome, have 16% upside over the next 12 months. S&P target is 1,565.

Scenario No. 2 (probability 5%): The U.S. enters a recession precipitated by a loss of business and consumer confidence, producing a fall in manufacturing output and personal consumption expenditures. A series of bank failures and sovereign debt defaults in the eurozone contribute to a deep European recession and a hard landing in China and India. S&P 500 earnings estimates for 2012 are materially slashed to $75 to $80 per share. Stocks, valued at 10.0x under this outcome, have 42% downside risk over the next 12 months. S&P target is 775.
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