This blog post originally appeared on RealMoney Silver on Nov. 11 at 7:44 a.m. EST.
Investors face unconventional headwinds today, both short and intermediate term.
As always, a sense of time frame is of paramount importance in matters of investing and trading. This might be more so today than in prior cycles as broad and systemic controversies have, by definition, uncertain outcomes and help to explain the almost unimaginable market volatility and the fatigue we all face when confronting routine intraday swings of 3% to 5%.
We have to be honest with ourselves and respect that the complexity of today's economic challenges renders the investment mosaic unusually ambiguous. It is
in any time frame.
I have emphasized that there are three important questions that we must ask ourselves in order to frame our stock market expectations. I'll present them again below but this time with my answers in italics:
- 1. How deep and long-lasting will the recession be?
While the largest year-over-year decline in GDP will probably be in the current quarter, it is unlikely that the economy will recover until late next year.2. Who will be the marginal buyer to sustain the current rally?
With mutual fund and hedge fund investors withdrawing capital at a record rate and corporations likely to husband their resources (at the expense of accelerating their corporate stock buybacks), it is difficult to see a materially improving demand/supply equation for equities over the next six months that would serve to sustain a market advance.3. To what degree have current market prices discounted a weakening earnings and economic picture?
Arguably, stock prices have, to some degree, discounted the weaker economic and profit backdrop.
The Short Term
There are a number of short-term influences:
- Obviously, we have the selling associated with hedge fund redemptions.
- Also, we must consider the degree to which fiscal and monetary policy will affect the slope of the economy.
- Whither the emerging markets?
- How broad will the Treasury's umbilical chord of capital need to be in order to stabilize the credit markets?
- How long is the toxic reach of the arms of American International Group (AIG) - Get Report and Lehman Brothers?
- Will there be a bailout of the automobile manufacturers?
- What will be the effect of the change in our government's leadership?
- Finally, remember that we have entered a period of seasonal year-end market strength.
Given that there are so many moving parts to the investment equation, about the only thing I am comfortable in writing with certainty is that we will see continued volatility.
Generally speaking, the market's short-term upside will likely be contained by the limited visibility in corporate profits and economic growth. By contrast, the market's short-term downside should be contained by the extreme negative sentiment readings, substantially lowered economic and market expectations and a historically aggressive public policy that is intended to address the lingering credit issues and to repair the world's weakened financial system.
My best guess is that the market will fluctuate within a very broad trading range of plus- or minus-10% to 15% in either direction from today's
level -- but, then again, a 10% move is only the average of three days trading! -- making very little progress over the next several months. In this environment, investors may only deliver superior performance by being opportunistic and by processing ideas quickly and intelligently. I'll say it again: It is an exquisite trading market, not an exquisite investing market to which most investors are accustomed.
The Intermediate Term
The intermediate term is the tricky issue for me. Typically, economic and financial problems do work out, and markets tend to recover from shocks. From my perch, however, the intermediate term is still murky, clouded by the uncertainty of the magnitude of the financial, stock market and economic shocks over the past 12 months. The threats, ramifications and challenges of the long tail of the credit mess, the dysfunctional financial intermediaries that finance economic growth, the broadening weakness in the consumer and the impact of the breakdown in stock and home prices (on the consumer, our universities, municipalities and other institutions) remain in doubt.
As I wrote in "
" last week, the outlook for the next three to five years has been jarred. Our social, economic and political future has materially changed, owing to the deep and muddy financial ditch in which we are now squarely stuck. Moreover, the scope and duration of the financial meltdown has placed our economy well past the tipping point, and it will have an enduring and negative intermediate-term effect. Consider that U.S. home prices have dropped by over $5 trillion in the last one and a half years and that, during the month of October alone, nearly $10 trillion has been lost in the global equity markets. Quite frankly, that ditch is so deep right now that we are in big trouble if our policymakers get it wrong over the next 12 months. My concern is that we might even be in trouble for a long period of time if they get it right.
By definition (and not surprisingly), the optimists like the dreams of the future better than the history of the past, but the fault I see in using previous recessionary examples is that history (and those charts) fails to recognize that
on so many fronts but particularly as it relates to the accumulation of debt and credit. By contrast, the pessimists (who might be the realists) see the aforementioned past policies and argue (perhaps more correctly) that the past is gone, the present is full of confusion and that the future scares the hell out of them.
I went on to write that, for decades, U.S. investors have seen the hereafter as an expected gift but in reality the future is earned -- it is based on achievement. Unfortunately, never has a generation spent so much of our children's wealth in such a short period of time with so little to show for it.
In summary, there will be broad-based social, political, credit, economic and stock market ramifications from the economic and market jolts of the last 18 months. Few of these are P/E-multiple-elevating developments, and the emerging trends (if I am even partially accurate) will likely produce an uncertainty of outcomes that make it difficult to glibly conclude that the market's dramatic decline has now been fully discounted and almost certainly even questions the market's intermediate-term upside.
The message of the market remains clear:
- An economic recovery is not nearly as visible as the optimists would like you to believe. There remains a long tail to today's problems.
- Credit will remain dear, despite evidence of a statistical thaw in credit -- the three-month LIBOR stands at 2.18% (down from a peak of 4.75%), the TED spread is at 1.7% (down from a recent peak of 4.60%), two-year bank swap spreads are at 105 basis points (down from 160 basis points), the LIBOR/Overnight Spread is at 1.6% (down from a recent peak of 3.60%); all these measures are now below pre-Lehman bankruptcy readings -- as pendulums nearly always move to the opposite extreme.
- Finally, the uncertainty regarding corporate profits (i.e., the lifeblood of a bull market) remains the single most important reason why, over the foreseeable future, a sustained rally in equities seems unlikely.
This does not mean that the market is doomed. In the current and prospective environment, superior returns can be delivered through facile trading and proper industry/sector selection. What it does mean is that the market is challenged, both short and intermediate term.
As I look realistically into the future, my crystal ball remains cloudy.
Erring on the side of conservatism remains the proper course for most investors.
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AIG operates in the property and casualty insurance industry, and some of the other stocks in its field include
The Travelers Companies
The Chubb Corporation
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At the time of publication, Kass and/or his funds had no positions in the stocks mentioned, although holdings can change at any time.
Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.