25 Surprises for 2007

In Kass' crystal ball, a private-equity takeover of CAT and TI, and plummeting stocks.
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This piece originally appeared on Street Insight on Dec. 11 at 8:21 a.m., and is being republished as a bonus for TheStreet.com and RealMoney.com readers. For more information about subscribing to Street Insight, please click here.

Every December, I take a page from former Morgan Stanley strategist Byron Wien, now the chief investment strategist at Pequot Capital Management, and prepare a list of 25 possible surprises for the coming year.

These are not intended to be predictions but rather events that have a reasonable chance of occurring despite the general perception that the odds are very long. I call these "possible improbable" events.

The real purpose of this endeavor is to consider positioning a portion of my portfolio in accordance with outlier events -- with large payoffs. After all, Wall Street research is still very much convention and "groupthink," despite the reforms over the past several years. Mainstream and consensus expectations are just that, and in most cases they are deeply imbedded into today's stock prices. If I succeed in making you think about outlier events, then the exercise has been worthwhile.

Also, not all of these surprises are stock- or market-related; I also delve into some popular-culture issues in the business world to mix things up!

About one-third of last year's

predicted surprises

actually happened, up from 20%

in 2005

. Nearly one-half of our prognostications proved prescient in

2004 and about one-third in

2003.

Our most accurate sprang from a variant view of prices of a broad range of commodities -- specifically the prices of the CRB Index, crude oil and gold. We expected the CRB Index to approach 375 (it stood at only 326 when the Surprise list was published a year ago and peaked at 368 in early summer); we expected the price of crude to rise to $80 per barrel (exactly the price crude hit in July) and suggested that gold might rise to above $675 per ounce.

  • Gold reached $740 in May 2006. Our expectation of a sharp drop in the U.S. dollar was also realized.
  • We accurately assessed the Federal Reserve's continued interest rate increases (despite the general view that the Fed would pause) earlier in the year. At the same time, our variant view that bond yields would rise in the first half of 2006 and then decline in the year's second half -- in the face of a deceleration in the rate of domestic growth -- was spot on.
  • We were spot on that the rate of growth in retail sales would slow in the second quarter of 2006 and that several highflying specialty retailers like Williams-Sonoma (WSM) - Get Report and Urban Outfitters (URBN) - Get Report would have disappointing same-store sales, although a large drop in crude oil and natural gas restored retail strength in the early fall.
  • As we suggested, a Long Term Capital-like hedge fund failure did occur, as Connecticut-based Amaranth's losses were on a par with the losses generated at LTC.
  • As forecast, China and India's economic growth surprisingly continued in an uninterrupted fashion, but the outgrowth of weak median incomes for the average American worker stimulated more than 27 separate pieces of anti-China trade legislation in Congress.

25 Possible Surprises in 2007

1

. Private-equity deals begin the year in a spectacular fashion, with two separate $50 billion acquisitions in January. A consortium of Silver Lake Partners, The Blackstone Group, Kohlberg Kravis Roberts, Texas Pacific, Bain Capital and

Goldman Sachs

(GS) - Get Report

acquire

Texas Instruments

(TXN) - Get Report

. Kohlberg Kravis Roberts leads a syndicate in the takeover of

Caterpillar

(CAT) - Get Report

, the 55th largest company in the

S&P 500

.

Later in the month, one of the largest buyouts in the history of the media and entertainment industry is made by Bain Capital and Thomas H. Lee Partners when they acquire

CBS

(CBS) - Get Report

for $30 billion.

In early February, Goldman Sachs (teaming up with Warren Buffett's

Berkshire Hathaway

(BRKA)

) announces that it is considering a going-private transaction. The Goldman deal is abandoned three months later, as a fractured mortgage market leads to a standstill in deal-making as the capital markets (and underwriting activity) seize up.

2

. Robert E. Rubin returns to his brokerage roots and becomes the CEO and chairman of Salomon Brothers/Smith Barney after

Citigroup

(C) - Get Report

decides to break up into three separate companies: a domestic money-center bank (Citibank), an investment banking/retail brokerage (Salomon Brothers/Smith Barney) and an international consumer finance company (Citiglobal).

3

. Based on misleading government statistics, the housing market appears to stabilize in the first quarter of 2007. For a few months, those forecasting a bottom in residential real estate appear vindicated. Evidence of cracks in subprime credits are ignored, with housing-related equities soaring to new 52-week highs by March 1.

4

. However, continued heavy cancellations of home contracts -- which are included in the government releases on homes sold and lead to

an erroneous inventory of unsold units for sale -- lead to:

  • A dumping of homes on the market in the spring
  • A quantum increase in the months of unsold housing inventory
  • A dramatic drop in the average home selling price.

Sales of existing and new homes take another sharp leg lower as we enter what I've dubbed "The Great Housing Depression of 2007."

Importantly, the financial intermediaries that source mortgage financing/origination begin to feel the financial brunt of "The Great Mortgage Bubble of 2000-06" after years of creative but nonsensical, low or nondocumented lending behavior.

5

. Foreclosures steadily rise over the course of the year to nearly 3 million homes in 2007 vs. about 1.2 million in 2006. Deep cracks in the subprime market spread to other credits in the asset-backed securities market as a lumpy and uneven period of domestic economic growth takes its toll. In a similarly abrupt and dramatic manner, credit spreads fly open and revert back to mean valuations, as previously nonchalant investors are awakened to the reality of credit risk.

6

. The magnitude of the credit problems in mortgages takes its toll on the hedge fund industry, which is much more exposed to real estate than generally recognized. A handful of multibillion-dollar, derivative-playing hedge funds bite the dust in the aftermath of the housing debacle. Several California-based industrial banks fail (the West Coast is always at the leading edge of financial creativity and leverage!), and a large brokerage firm, heavily involved in fixed-income market-making and trading, faces material losses, and its debt ratings are downgraded. As the financial contagion spreads, rumors of a $10 billion-plus derivative loss at

JPMorgan Chase

(JPM) - Get Report

(which ultimately prove to be false) spark the largest one-day percentage drop in its shares in the past 15 years.

7

. In a panic, Congress announces a series of hearings on the derivative industry, and the Federal Reserve reduces the fed funds rate by 50 basis points in each of three consecutive meetings. Those efforts are too late to affect the already weakening economy as the long tail of housing begins to affect not only consumer confidence and spending but also other peripheral areas of the economy.

8

. Commodity prices begin to collapse even before the mortgage market fiasco, but the onset of the decline is initially ignored by stock market investors. The CRB Index moves below 300. Notably, crude oil falls under $50 in a deflationary scare as interest rate cuts fail to revive the economy. The yield on the 10-year U.S. note falls to below 4% and stays there over the balance of the year.

9

. Corporate profits for 2007 end up virtually flat year over year, but the pattern is inconsistent. After rising 8% in first-quarter 2007, corporate profits are down 5% in second-quarter 2007, up by 2% in third-quarter 2007 and back down by 4% in fourth-quarter 2007.

10

. Equity-market volatility, like credit spreads, rises exponentially. The S&P 500 routinely has 2% daily moves, acting more like a commodity than a stock index. Mutual fund and hedge fund redemptions rise dramatically.

11

. Stocks begin 2007 the way they ended 2006 -- very strong -- and the S&P 500 temporarily breaches 1450 in February. But by the end of the second quarter, under the brunt of the mortgage implosion, stocks drop nearly 15% and remain relatively range-bound for the rest of the year. The S&P 500 ends the year at around 1250, dropping by about 11% in 2007.

Reflecting the deflationary threats, one of the best-performing groups of 2006, industrial materials, morphs into the worst-performing group in 2007. With credit spreads flying open, the junk-bond market records its worst performance in over two decades and substantially underperforms almost every asset class in 2007. Technology, pinched by an abrupt demand plunge in consumer electronics, a listless response to

Microsoft's

(MSFT) - Get Report

Vista and a drop in business spending, ends the year with a 20% decline in value.

12

.

Fidelity Management

announces the introduction of its first dedicated short equity product.

Alliance Capital

follows with a similar product shortly thereafter.

13

. With confidence in the markets and economies ebbing, merger-and-acquisition activity slows to a crawl by May. Several leading universities and endowments, which previously underwrote large private equity commitments, announce that they are dramatically reducing their exposure to that asset class.

As the capital markets falter, institutional funds committed to real estate are also reined in, initially leading to a marked slowdown in the recent appreciation in office building values. While broadening economic weakness leads to only a slight rise in office vacancy rates, as the year progresses vacancy rates deteriorate more noticeably. REIT shares get hit hard (and fall below net asset values) as the historic relationship between REIT dividend yields and the yield on the 10-year U.S. note mean regresses.

Click here for the second half of this list.

At time of publication, Kass and/or his funds were short JPM, MSFT and WSM, 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. 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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