This commentary originally appeared at 7:23 a.m. EST on Feb. 21 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.
"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"
closed on Friday at 1362, slightly above my fair market value calculation of 1345.
Modeling for an S&P 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 my 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.
Selling the Greek Debt Agreement News
While I recognize the positive price momentum and the possibility of a further overshoot of my fair-value calculation, I remain cautious over the shorter term.
Indeed, the Greek debt agreement this week might very well mark a classic sell-on-the-news event.
I continue to have an optimistic intermediate-term outlook on the market, and I expect the S&P 500 to range in price between 1250 and 1550 for the full year. (That's 2:1 upside vs. downside.)
That said, over the near term, the S&P 500 now appears slightly overpriced after this year's consistent rise, and I expect the index to be bound within a price range between 1250 and 1400 over the next few months. (That's slightly more than a 2:1 downside vs. upside.)
In other words, to me, the broader market provides little immediate value over the shorter term today.
last week the world's markets have continued their low-volume melt up as conditions were ripe for an advance:
Anecdotally (and not surprisingly), investor sentiment, which was so dismal at the start of 2012, has now begun to reverse quickly. Sideline cash has worked itself into the markets, as evidenced by the consistent rally in the first six weeks of the year, and, in turn, the business media are now populated by a chorus of talking heads that are singing "Everything Is Coming Up Roses."Most investor surveys indicate a substantial rise in bulls and decline in bears over the past few weeks: Investors Intelligence bulls (52%), the National Association of Active Investment Managers bulls (73%) and Consensus Inc. (stock traders) bulls (72%) are at the highest levels in 12 months, 10 months and 13 months, respectively. The CBOE 10-day put/call ratio is down to 0.84, or at the lowest reading since April 2011. Barron's' cover this past weekend contained the headline "Dow Jones 15,000," and even doomsayer Dr. Nouriel Roubini is now a market optimist.
But that was then, and now, after the gold rush, the ratio of reward to risk has turned less favorable, as market expectations have advanced with higher stock prices:
Chasing stocks (in either direction) is not my modus operandi, as my investment mantra is that price is what you pay but value is what you get.Even in a fairly priced market, however, in which reward and risk are generally in balance, one can still select long positions that can outperform the indices and shorts that will underperform the indices. Importantly, I am hopeful that, in a still volatile market, I can add alpha to my long and short investment positions by trading opportunistically (the cash register effect).
Dr. Doom Says So, and I Agree
I share with
several near-term concerns that could undermine valuations, jeopardize global economic growth, reduce investor confidence and impede improvement in valuations.
- the price of oil (on Monday it rose to $105 a barrel);
- broadening geopolitical risk in the Middle East;
- a slowdown in the emerging markets (especially in China and India);
- the continued reliance on monetary policy (and neglect of pro-growth fiscal policy);
- an unrealistic U.S. budget that is dependent upon assumptions that would embarrass even the tooth fairy; and
- the changing political backdrop, which now favors an incumbent presidential win.
The last factor deserves an expanded discussion as it has decidedly changed (as far as markets should be concerned for the worse) over the last few weeks.
Detroit Is Back on Top, and Osama bin Laden Is Dead
These words (of President Obama's campaign) carry a simple but hard-hitting message.
By contrast, the Republicans' message appears to be growing more ambiguous and diffused. More precisely, the name of the Party's messenger has grown ever more vague.
Politics aside, there is little question to most investors that a November triumph by the Republicans will be seen as more market- and business-friendly than a Democratic win.
For now, the Republican Party appears to be snatching defeat from the jaws of victory.
If politics is a learning experience, it seems that the Republican Party has learned little in its combat with the opposition. Frontrunner Mitt Romney appears to have caved under the pressure from the other candidates. Specifically, he appears to be running scared as Rick Santorum gains momentum, as Ron Paul's core base remains stable and as an angry Newt Gingrich refuses to give up.
Meanwhile, a better jobs picture and continued improvement in the domestic economy further favor an incumbent win.
Reflecting these conditions (and others),
for the first time in eight months. And
are all moving decisively in the direction of a Democratic win. Mitt Romney's odds of getting the Republican nomination has turned down from over 90% to close to 70%, while Barack Obama's odds of winning the presidency has moved from nearly 50% to almost 60%.
Updated Fair Market Value Calculation for the S&P 500
My starting point when I construct my portfolio and determine exposures is always valuation.
There is no change from last week in my calculation of fair market value. Again, here is the criteria I use to evaluate the S&P 500 and upon which I conclude that fair market value is approximately 1345 (or about 1.3% below Friday's closing price):
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.Scenario No. 3 (probability 25%): The U.S. experiences a disappointing sub-1% real GDP growth rate, and Europe experiences a medium-scale recession. S&P 500 profit forecasts for 2012 are cut back to $98 to $100 a share (only slightly above 2011's levels). Stocks, valued at 12x under this outcome, have 12% downside risk over the next 12 months. S&P target is 1185.Scenario No. 4 (probability 45%): The U.S. muddles through with 1.5%-2.0% real GDP growth, and the European economies suffer a modest (but contained) business downturn. S&P 500 profits for 2012 trend toward a range of $103-$105 a share as some margin slippage occurs. Stocks, valued at 13.25x under this outcome, have 2% upside over the next 12 months. S&P 500 target is 1,375.
The Ingredients for a New High in the S&P 500 in 2012
As I did last week I will now shift my narrative from the near term to the intermediate term, for it is the intermediate term that still excites me as an investor.
Many strategists, who started the year less sanguine, have recently raised their S&P price targets to reflect the walkup in share prices.
I disagree in raising targets based on gains in the price of the indices, as, in order for the markets to approach all-time highs in 2012 (which I continue to view as possible), much must go right.
My ambitious 1550 target for the S&P 500 (first offered in December 2011, when investor sentiment was sour) seems substantially less of an outlier today than two months ago. It would require the revival of animal spirits driving valuations back to average historical levels, which would be a difficult but not impossible feat given economic, geopolitical and political uncertainties and within the context of the headwinds of our country's fiscal imbalances.
Below are 10 important factors that I continue to monitor -- with current trends in parentheses. These indicators are in neutral with five are moving positively and with the other five moving negatively:
An improving U.S. economy (+): Economic statistics (PMIs, ISMs, leading indicators, housing and jobs) must continue to be on the mend. But the recent rise in the price of commodities (especially oil) could begin to eat into corporate margins and profits. (Margin slippage has already commenced.)
A soft landing in India and China (-): Growth is moderating while inflation is accelerating. This weekend's reduction in China's bank reserve requirements is, to me, a signal that China's growth is decelerating more rapidly than expected by authorities.
Broad-based technical strength (-): The market's breadth has started to narrow (often a sign of a potential top), as a few high-profile stocks seem to be responsible for most of the recent advance. Indeed, one might describe this as "the NBA market," as in "nothing but apple." Recent gains on lower volume bear watching, as that trend typically marks a negative technical divergence.
Reduced volatility (+): Market volatility must continue to subside. It has trended lower throughout January but has recently started to rise.
Political compromise in the U.S. (-): Our political leaders must become less divisive and less divided. Unfortunately, as we move closer to the November elections, compromise (leading to pro-growth fiscal initiatives) seems a more distant possibility.
Global monetary ease (+): I remain confident that central bankers around the world will continue to keep interest rates low.
Containment of the eurozone debt crisis (+): Europe's central bankers and leaders must continue to implement policy that contains the debt contagion (as they have in recent months). But the heavy lifting of fiscal policy lies ahead -- and history is not on Europe's side.
Reduced geopolitical risk (-): If anything, the tension between Israel and Iran has intensified.
Prospects for a Republican presidency (-): As previously discussed, politics aside, history shows and most investors today view a Republican victory as business- and market-friendly. Recent Romney caucus and primary losses, however, have improved the chances of the Democrat Party recapturing the presidency.
Improving fund flows (+): The multiyear trend in which individual investors and hedge funds retreat from U.S. equities must be reversed. Retail investors have begun to commit money into domestic equity funds over the past three weeks, and ISI's hedge fund survey indicated a sharp increase in net long exposure last week.
In summary, reflecting the above variables, I am slightly net short in my hedge fund.
At the time of publication, Kass and/or his funds were short SPY common and calls, although holdings can change at any time.
Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.