Kass: Joy Before the Market Storm

History tells us euphoria often precedes violent declines.
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This column was originally published on Street Insight on April 12 at 8:38 a.m. EDT. It's being republished as a bonus for TheStreet.com and RealMoney.com readers. For more information about subscribing to Street Insight, please click here.

"Live by the harmless untruths that make you brave and kind and healthy and happy."

-- Kurt Vonnegut,

Cat's Cradle

The

Federal Reserve

set the record straight yesterday and in a direct and succinct fashion emphasized its policy dilemma. Downside economic-growth risks "had increased in the three weeks since the January meeting ... and the latest information cast some doubt on whether core inflation was on the expected downward path."

A housing-induced slowdown (with all the attendant credit implications of a subprime meltdown) coupled with stubbornly high inflation spells stagflation, and stagflation is the recipe for contracting corporate profit margins and disappointing corporate profits. And, perhaps, lower stock prices.

Whether Wednesday's drop is the start of another market correction is unknown. But, it should be noted that a general feeling of euphoria often precedes violent moves downward.

And I am sticking with my analog that the advance from the deeply oversold lows in the

DJIA

in 1932 to 1937 could resemble the current

Nasdaq

(and DJIA) 2002 to 2007 run -- with a slight twist.

If you go back to a chart of the Dow Jones Industrial Average in 1937, you will observe that the market's breadth peaked coincidentally with the DJIA in March 1937, but lagged badly during the failing rally into August. The rally from late February 2007 -- which might now be failing -- had relatively good breadth.

So in order for this year's picture to resemble that of 1937, we probably would require a test of the early March low (or a new low) and then an ensuing rally with weak breadth and volume divergences throughout the early summer of 2007.

And, then, the market might decline dramatically, as it did from August 1937 into early 1938.

I have been fading away from the copious complacency and the growing and misguided view (at least before yesterday) that the Federal Reserve will cut interest rates.

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. Until 1996, he was senior portfolio manager at Omega Advisors, a $4 billion investment partnership. Before that he was executive senior vice president and director of institutional equities of First Albany Corporation and JW Charles/CSG. He also was a General Partner of Glickenhaus & Co., and held various positions with Putnam Management and Kidder, Peabody. Kass received his bachelor's from Alfred University, and received a master's of business administration in finance from the University of Pennsylvania's Wharton School in 1972. He co-authored "Citibank: The Ralph Nader Report" with Nader and the Center for the Study of Responsive Law and currently serves as a guest host on CNBC's "Squawk Box."

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