Doug Kass: 15 Surprises for 2013
By Doug Kass 01/09/13 - 07:59 AM EST
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This column originally appeared on Real Money Pro at 7:15 a.m. EST on Jan. 7.
NEW YORK (Real Money) --
"Never make predictions, especially about the future." -- Casey StengelIt's that time of the year again! It was a tough task repeating the success of my surprise list for 2011 over the past year. This is particularly true since my most important surprise (No. 4) in 2011 -- namely, that the S&P 500 would end the year at exactly the same price that it started the year (1257) -- was eerily prescient. As well, in 2011 I basically nailed that the trading range over the course of that year would be narrow (between 1150 and 1300). As we entered 2012, most strategists expressed a relatively sanguine economic view of a self-sustaining domestic recovery and an upbeat corporate profits picture but shared the view that the S&P 500 would rise but only modestly. By contrast, I called for a much better equity market -- one capable, in the second half of the year, of piercing the 2000 high of 1527. As it turns out, the S&P 500 breached 1480 to the upside in the fall -- or about only 3% less than the 2000 peak. (In October, I concluded that the S&P 500's fair market value was 1415, and the S&P closed the year just 10 points higher than that figure.) Before reviewing what else went right in my surprise list for 2012 (and what went wrong), I wanted to give some historical perspective on the lessons of the past, on the role of the consensus and what I am trying to bring to the table in the construction of the surprise list.
Lessons Learned Over the Years
"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown." -- Woody AllenThere are five core lessons I have learned over the course of my investing career that form the foundation of my annual surprise lists:
- how wrong conventional wisdom can consistently be;
- that uncertainty will persist;
- to expect the unexpected;
- that the occurrence of black swan events are growing in frequency; and
- with rapidly changing conditions, investors can't change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.
Consensus Is Often Wrong
"Let's face it: Bottom-up consensus earnings forecasts have a miserable track record. The traditional bias is well known. And even when analysts, as a group, rein in their enthusiasm, they are typically the last ones to anticipate swings in margins." -- UBS's top 10 surprises for 2012Let's get back to what I mean to accomplish in creating my annual surprise list. It is important to note that my surprises are not intended to be predictions but rather events that have a reasonable chance of occurring despite being at odds with the consensus. I call these "possible improbable" events. In sports, betting my surprises would be called an "overlay," a term commonly used when the odds on a proposition are in favor of the bettor rather than the house. The real purpose of this endeavor is a practical one -- that is, to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs on small wagers/investments. Since the mid-1990s, Wall Street research has deteriorated in quantity and quality (due to competition for human capital at hedge funds, brokerage industry consolidation and former New York Attorney General Eliot Spitzer-initiated reforms) and remains, more than ever, maintenance-oriented, conventional and groupthink (or groupstink, as I prefer to call it). Mainstream and consensus expectations are just that, and in most cases, they are deeply embedded into today's stock prices. It has been said that if life were predictable, it would cease to be life, so if I succeed in making you think (and possibly position) for outlier events, then my endeavor has been worthwhile. Nothing is more obstinate than a fashionable consensus, and my annual exercise recognizes that over the course of time, conventional wisdom is often wrong. As a society (and as investors), we are consistently bamboozled by appearance and consensus. Too often, we are played as suckers, as we just accept the trend, momentum and/or the superficial as certain truth without a shred of criticism. Just look at those who bought into the success of Enron, Saddam Hussein's weapons of mass destruction, the heroic home-run production of steroid-laced Major League Baseball players Barry Bonds and Mark McGwire, the financial supermarket concept at what was once the largest money center bank Citigroup (C), the uninterrupted profit growth at Fannie Mae (FNM) and Freddie Mac (FRE), housing's new paradigm (in the mid-2000s) of noncyclical growth and ever-rising home prices, the uncompromising principles of former New York Governor Eliot Spitzer, the morality of other politicians (e.g., John Edwards, John Ensign and Larry Craig), the consistency of Bernie Madoff's investment returns (and those of other hucksters) and the clean-cut image of Tiger Woods.
"Consensus is what many people say in chorus but do not believe as individuals." -- Abba Eban (Israeli foreign minister from 1966 to 1974)In an excellent essay published two years ago, GMO's James Montier made note of the consistent weakness embodied in consensus forecasts. As he puts it, "economists can't forecast for toffee."
They have missed every recession in the last four decades. And it isn't just growth that economists can't forecast; it's also inflation, bond yields, unemployment, stock market price targets and pretty much everything else.... If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared! -- James MontierBy means of background and for those new to Real Money Pro, 10 years ago, I set out and prepared a list of possible surprises for the coming year, taking a page out of the estimable Byron Wien's playbook, who originally delivered his list while chief investment strategist at Morgan Stanley (MS) then Pequot Capital Management and now at Blackstone (BX).
Dueling Annual Surprise Lists: Kass vs. WienEvery year I, and many others, look forward to Byron "Brontosaurus Rex" Wien's annual compilation (hat tip to "Squawk Box's" Joe Kernen for giving him the moniker). Byron has had a remarkable (and almost uncanny) record of his surprises becoming realities ever since he started his exercise back in 1986. His picks in 2009 were particularly accurate, but his surprises for 2010-2011 were considered by some to be off the mark. The tone of almost all Byron's 2011 surprises was diametrically opposed to my list -- namely, his list was rooted in optimism, while my list was rooted in pessimism. Where I saw slowing and sluggish economic growth, a weak housing market, a European recession by year-end and a lackluster stock market, Byron saw improving prospects. His principal surprises for the economy, interest rates, housing, the eurozone's debt crisis and the housing markets were off the mark in 2011. (Byron is an honest guy, so he would be the first to admit this.) Specifically, Byron expected U.S. real GDP growth of close to 5% (real U.S. GDP over the 12-month period saw only a 1.8% growth rate), a 5% yield on the 10-year U.S. note (which stood at 2.03% by year-end 2011, but, hey, I got that one wrong, too!), a year-end S&P 500 close near 1500 (it closed at 1257), a sharp recovery in housing starts to 600,000 and a rise in the Case-Shiller Home Price Index, and a quiescent and non-market-disruptive European debt situation. He was very correct on the price of gold (where I was far off base) and on benign inflationary pressures. In 2012 Byron batted about .500 -- more or less in line with my batting average. He was correct in his upbeat forecast for stock prices, oil prices, the strength in corporate profits, the results of the Presidential election, a EU plan that successfully stabilized and ring-fenced the sovereign debt problem, the intensification of cyberwarfare, the strength in the U.S. housing market and that the price of gold would hit $1,800 an ounce. His optimism on domestic economic growth proved wrong, as did his view that the Democrats would take back the House. Similar to myself, Byron expected a less dysfunction in Washington, D.C. -- the opposite occurred. He was too optimistic regarding China and other emerging stock markets, and his forecast of a 4% 10-year U.S. note yield was way off mark. Last Wednesday Byron Wien presented his 10 surprises for 2013 (and five also-rans). For the first time in years there is a large overlap in our surprise lists this year
How Did Consensus Do in 2012?As we entered 2012, consensus estimates for economic growth and stock market prices were modest, corporate profits expectations were upbeat and projections for bond prices were lower and for bond yields higher. As is typical, most estimates were grouped in an extraordinarily tight range. Last year, I chose to use Goldman Sachs' (GS) forecasts as a proxy for the consensus. Below were Goldman Sachs' year-ago forecasts for 2012 (with the actuals in parentheses and boldface):
- 2012 U.S. real GDP up 1.8% (+2.3%), and global GDP up 3.2% (+3.1%);
- 2012 S&P 500 operating profits of $100 a share ($100 a share);
- year-end 2012 S&P 500 price target at 1250 (1425);
- 2012 inflation of +1.7% (+2.6%); and
- 2012 closing yield on the U.S.10-year Treasury note at 2.50% (1.80%).
How Did My Surprise List for 2012 Do?Last year's surprise list achieved about a 50% hit ratio, similar to my experience in 2011. Forty percent of my 2010 surprises were achieved, while I had a 50% success rate in 2009, 60% in 2008, 50% in 2007, one-third in 2006, 20% in 2005, 45% in 2004 and one-third came to pass in the first year of my surprises in 2003. Below is a report card of my 20 surprises for 2012 (I hit on 50% of the surprises): Surprise No. 1: The U.S. stock market breaches the 2000 high of 1527. Right. I call this correct as: 1. this was a hugely out of consensus and bullish view; 2. the S&P came within 3% of 1527; and 3. in September I reduced my year-end price close for the S&P 500 to 1415. (It closed at 1425.) Surprise No. 2: The growth in the U.S. economy accelerates as the year progresses. Wrong. Surprise No. 3: Former Presidents Bill Clinton and George Bush form a bipartisan coalition that persuades both parties to unite in addressing our fiscal imbalances. Wrong. Surprise No. 4: Despite the grand compromise, the Republican presidential ticket gains steam as year progresses, and Romney is elected as the forty-fifth President of the United States. Wrong. Surprise No. 5: A sloppy start in arresting the European debt crisis leads to far more forceful and successful policy. Right. Surprise No. 6: The Fed ties monetary policy to the labor market. Right. Surprise No. 7: Sears Holdings (SHLD) declares bankruptcy. Wrong. Surprise No. 8: Cyberwarfare intensifies. Right. Surprise No. 9: Financial stocks are a leading market sector. Right. Surprise No. 10: Despite the advance in the U.S. stock market, high-beta stocks underperform, but Apple (AAPL) is a standout to the upside. Right. Surprise No. 11: Mutual fund inflows return in force. Wrong. Surprise No. 12: We'll see merger mania. Wrong. Surprise No. 13: The ETF bubble explodes. Wrong. Surprise No. 14: China has a soft landing (despite indigestion in the property market), and India has a hard landing. Right. Surprise No. 15: Israel Attacks Iran. Wrong. Surprise No. 16: Bank of America (BAC) is forced to raise an additional $20 billion-$25 billion, and Brian Moynihan resigns as President. Wrong. Surprise No. 17: The CBOE Volatility Index (VIX) falls to the 10-15 level during the second half of 2012. Right. Surprise No. 18: Facebook's (FB) IPO fizzles and breaks issue price in the first day of trading. Right. Surprise No. 19: A second-half growth scare briefly lifts the yield on the 10-year U.S. note to over 3%. Wrong. Surprise No. 20: Three very high-profile executives of Fortune 500 companies are forced to resign after sexual harassment allegations. Right.
What Is the Consensus for 2013?As we enter 2013, investors and strategists are again grouped in a narrow consensus on economic growth (+2% real GDP), bond yields (higher) and year-end 2013 closing stock market price targets (on average at about 1575, a gain of 10%). On the latter issue of stock prices, strategists are unusually tight in their year-end S&P 500 forecasts, with Bank of America, Bank of Montreal, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, KKR, JPMorgan and Oppenheimer all in the range between 1550 and 1615, representing, on average, about a 10% gain for the full year. BTIG and Barclays are at 1525. Only UBS (1425) and Morgan Stanley (1434) stand out from the crowd. Again, let's use Goldman Sachs' principal views of expected economic growth, corporate profits, inflation, interest rates and stock market performance as a proxy for consensus. Here are Goldman Sachs' forecasts for 2012, 2013 and 2014:
The Rationale Behind My Downbeat Surprises for 2013
- No meaningful spending or entitlement cuts will be made;
- Unsustainable and diminished value of fiscal and monetary policy;
- An aging recovery and aging stock market;
- Investment narrative shifts to the earnings cliff and to the end of profit margin expansion;
- A market that starts the year at reasonable if not high valuations relative to headwinds;
- Full-year estimated S&P 500 range of 1275-1480 with a close of 1425; and
- Fade (sell/short) early January stock market strength.
"Say what you will about Congress, but it has created jobs for people who would be unfit to work anywhere else." -- Andy BorowitzLast year my surprise list had an out-of-consensus positive tone to it, but this year it is noticeably downbeat relative to generally upbeat expectations. As contrasted to 2012, when most were dour in market view (and wrong!), the 2013 consensus is an optimistic one and now holds to the view that European economic growth is stabilizing while growth in China and in the U.S. is reaccelerating. The popular view goes on to believe that even our dysfunctional leaders in Washington will not upset the growing consensus that it is clear sailing for equities and trouble ahead for bonds. Once again, the bullish consensus is tightly grouped with the expectation that the S&P 500 will close the year at 1550-1615 (up from 1425 at the close of 2012) and that the 10 year U.S. note yield will trade at 2.50% or higher (up from 1.80% at the close of 2012). These consensus views might prove too optimistic on stock prices and too pessimistic on bond prices. I believe that the U.S. stock market will make its 2013 high in the first two weeks of January, be in a yearlong range of 1275-1480 and close the year at 1425 and that the 10-year U.S. note will be below 2.00% in the first six months of 2013. Many of my more downbeat surprises for 2013 are an outgrowth of an aging economic recovery (now four years old), a maturing stock market (of a similar age!) coupled with the recognition that running trillions of dollars in deficits while maintaining zero interest rates are unsustainable policy strategies. I am also concerned that the multiplier being applied to the tax increases agreed to last week will be greater than many expect, serving to weigh on domestic economic growth. As well, it is also my view that the trajectory of economic growth in 2013 (and corporate profits) will also be adversely impacted by the manner in which businesses and consumers react to the tax hikes and the growing animosity and contentiousness in Washington, D.C., in the months ahead. Indeed, I fully expect the upcoming deliberations between the revenge-lusting Republicans in the House and the equally dogmatic and partisan incumbent President and Democratic Senate to not result in any meaningful cut in spending or entitlements reform. I do, however, expect these negotiations to have a direct and distinct adverse impact on economic growth, confidence and profits. The dependency on our economy and on business and consumer confidence to Washington's ability to compromise and deliver intelligent policy will prove, at the very least, unsettling to the markets in the year ahead. At worst, it will undermine the economic expansion. In addition, policy alternatives are diminishing. U.S. monetary policy is now effectively shooting blanks, and fiscal policy will now turn to be a drag on growth. Moreover, the likely reluctance and inertia by our leaders in addressing our budget will continue to turn off the individual investor class to stocks this year. Finally, my ursine tone is also a reflection that, by most measures, the U.S. stock market is not meaningfully undervalued and that given the dynamic of the headwinds of slowing economic growth, a poor profit outlook and the developing weakness of policy are unlikely to be revalued upward in 2013 (as many strategists suggest).