This blog post originally appeared on RealMoney Silver on July 21 at 8:21 a.m. EDT.
"To predict the behavior of ordinary people in advance, you only have to assume that they will always try to escape a disagreeable situation with the smallest possible expenditure of intelligence." -- Friedrich Nietzsche
We are now more than halfway through one of the most tumultuous and painful investing years in history, so it's time to grade and update our annual surprise list.
For a little background, in late December/early January in each of the past five years, I have taken a page from my friend and former Morgan Stanley strategist Byron Wien (now the chief investment strategist at Pequot Capital Management) and prepared a list of possible surprises for the coming year.
"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown." -- Woody Allen
The real purpose of this endeavor is to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs, and to disprove Nietzsche, who said that we live the same life over and over again. After all, Wall Street research is still very much conventional, almost universally bullish and consisting of nonvariant "groupthink" despite the attempts of reform 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 at least making you think about outlier events, then the exercise has been worthwhile.
Last year's (2007) surprise list was our most accurate ever. It wasn't the quantity of the correctly predicted surprises that made
a remarkable success; it was the quality, as I hit on nearly every major variant theme -- the severity of the housing depression, the turmoil and writedowns in the credit markets, the curtailing of private equity deals and the reawakening of equity market volatility.
"I don't want to make the wrong mistake." --Yogi Berra
As successful as the 2007 surprise list was, our 2008 list has proven to be even more accurate. Like the
newest Batman, there was a touch of demon in the market's stealthy menace and engrossing tragedy over the first six months of the year. As it is said, action is the antidote of despair, and attention to the 2008 surprise list could have saved investors quite a bit of money (especially by avoiding the finance sector). At our halftime intermission, here are my grades and updates for my surprises for 2008:
1. The Housing Depression of 2007 morphs into the Retail Spending Depression of 2008. Stubbornly high inflation coupled with a deceleration in the rate of job growth, which turns into job losses by midyear, and an absence of innovation (a creativity void in consumer electronic products and apparel), leads to an unprecedented and abrupt drop in personal consumption expenditures.The Retail HOLDRs (RTH) - Get Report exchange-traded fund declines to $80 from $94. Despite their apparent "value" today, retail stocks, especially women's apparel, are among the worst-performing stocks in the first half of 2008.
The Retail HOLDRs declined a swift $10 during the first two weeks of January, rallied back to almost $99 and now stands in the high eighties. More importantly, the evidence suggests that the housing problem has clearly begun to negatively affect personal consumption and retail stocks have been among the worst-performing market sectors in the latest selloff.
Going forward, I see no reason to alter this surprise. Indeed, the RTH could breach the $80 mark to the downside. While current retail cash flow multiples of 5 times to 6 times appear low and ripe for a rally, the 2008 to 2010 EBITDA expectations might prove to be too optimistic given the plight of the American consumer.
2. Under pressure from slowing consumer spending, disappointing capital spending and higher commodities, corporate profits drop by 10% in 2008. Importantly, the pattern of economic activity grows increasingly inconsistent and lumpy, providing a difficult backdrop for corporate managers and investment managers to navigate.
During the last few months, corporate profit forecasts have been dramatically reduced in the face of slowing retail sales, lower-than-expected capital spending and higher input costs. Depending upon the series one is using, the first half of 2008 produced about a 5% increase in profits.
The 10% surprise drop in 2008 corporate profits might be too aggressive, but, more importantly, the recent message of the market could be that a mean regression of profit margins is now at hand, U.S. industrial incomes could be on the verge of significant disappointment, and aggregate S&P profits might be mired in the $75-$85 level for three to five years to come.
3. The S&P 500 falls by 5 to 10% in 2008, and 2007's laggards and leaders continue to be the same laggards and leaders in the coming year.
The S&P has dropped by approximately 15% this year.
While a full year 10% to 15% market decline appears probable, a big surprise in the second half of the year could be that the market averages neither rally nor decline meaningfully from the current level.
4. With a continuation of the credit and liquidity crises and an increased recognition that financial retrenchment will take years (not months), volatility pushes even higher. Daily moves of 1% to 2% become more commonplace, serving to further alienate the individual investor.
Volatility has been the recurring theme of 2008.
Though more volatility is on top in the near term, a big surprise in the second half of the year could be that market volatility moderates back to historic levels and the stock market turns "boring."
5. The Federal Reserve embarks upon a series of moves to ease monetary policy in 2008. Nearly every meeting is accompanied by a 25-basis-point decrease in the federal funds rate, even despite continued inflationary pressures.Nevertheless, the economy fails to revive as the Fed pushes on a string.
While the Federal Reserve has been more aggressive than I expected, its impact has been disappointing to most observers. Inflation remains elevated as growth remains in question.
The Fed appears to be pushing on a string now, but rate drops will not likely be a prominent feature over the next six months.
6. Growth in the Western European economies deteriorates throughout the year, and the markets in England and France drop at twice the rate of the U.S. market.
The European markets have fallen more swiftly than the U.S. stock market, and their economies have deteriorated more meaningfully.
More of the same seems on tap as Western Europe suffers under a strong currency and seems to be three to six months behind the U.S.'s economic problems.
7. The Chinese juggernaut continues apace, and, despite continued protestations of a market bubble, the Chinese market doubles again in 2008.
Rising inflation, growth fears and a general weakness in emerging markets have crippled the Chinese markets.
China is beginning to show signs that it has become coupled with the rest of the world, and its market should end 2008 with decelerating growth and accelerating inflation.
8. The Japanese market puts on a surprising resurgence as the world's investors respond to compressed valuations (vis-à-vis peer regions), reasonable multiples (absolutely and against Japanese bond yields), accelerated M&A activity, share buybacks and relative strong corporate profit growth.
The Japanese market has fallen at about half the rate of the U.S. stock market.
I have no view of a surprise on this subject going forward.
9. The administration's proposal to revive the housing market falls on its face (as the housing bust accelerates), and President Bush enlists a well-placed Democrat and former cabinet member to become the U.S. housing czar, who has the primary charge to propose and administer a massive Marshall Plan for housing.Several high-profile housing-related bankruptcies occur in 2008, including Countrywide Financial, Beazer Homes (BZH) - Get Report, Hovnanian (HOV) - Get Report, Standard Pacific (SPF) , WCI Communities (WCI) and Radian Group (RDN) - Get Report.
While there were no bankruptcies, there were several bailouts and acquisitions that resembled bailouts (e.g., Countrywide Financial), and many of the aforementioned companies are on the financial edge. The housing initiatives have been roundly unsuccessful.
Two weeks ago, I suggested the need for both a housing and energy czar on "Kudlow & Company". I suspect most of these companies will continue to muddle through and their share prices will continue to be mired by weakening housing market conditions.
10. Financial stocks fail to recover. No financial company is immune to the eroding market conditions, the spike in market volatility, the uneven direction in commodities and currency prices. Even the leader of the pack, Goldman Sachs (GS) - Get Report, makes several bad bets in the derivative, currency and commodity markets, and its shares begin to underperform its peers as profit forecasts move lower. Citigroup (C) - Get Report halves its dividend, and the shares briefly trade in the mid-$20s. Asset sales and writedowns leave the bank crippled, and in late 2008 (after another capital infusion by Abu Dhabi), Citi is merged with Bank of America (BAC) - Get Report. Its new name is its old name: CitiBank! Bear Stearns is acquired by HSBC (HBC) in a take-under (well below today's price) -- as investor Joe Lewis loses nearly $350 million on his near-10% position in the brokerage firm.Mutual fund outflows and uncertainty regarding the integrity of money market funds result in the asset-management stocks being among the worst-performing sectors in 2008. With private-equity deals at a standstill, Blackstone (BX) - Get Report shares trade down close to $10 a share. Late in the year, CEO Stephen Schwarzman and his management group take the company private.
On every account, this surprise was extremely accurate, although Goldman Sachs, once again, did not slip up: Citigroup markedly reduced its dividend (and its shares are languishing in the high teens); Bear Stearns
acquired in a take-under, but by
, not HSBC; mutual fund outflows continue apace; and Blackstone's shares traded under $15.
A big surprise in the second half could be Goldman Sachs acquiring a large regional or money center bank and that last week's bank stock rally is the start of something larger to the upside.
11. With the economy weakening and corporate profits tumbling, investors pay up -- real up -- for growth. The three horsemen -- Research In Motion (RIMM) , Apple (AAPL) - Get Report and Google (GOOG) - Get Report -- move into bubble status, and short interest triples as the naysayers increase their bets. Their shares double in 2008 even as most equities decline.Technology disappoints as it becomes clear by the beginning of the second quarter that "double ordering" inflated recent revenue gains as the weakening consumers' appetite for electronics founders. Rapidly growing biotech names are embraced as their P/Es grow high into the sky and they become the New Big Thing, and market leaders. Housing-centric equities continue to deflate and mop up the rear.
Horesemen, after fading badly earlier have begun to outperform its' technology counterparts.
I still expect these shares to be conspicuous outperformers in the second half as the equity market pays up for growth.
12. Although private-equity M&A activity remains moribund, 2008 is highlighted by numerous mergers of equals as a weak U.S. economy necessitates the need for a strategy that produces synergies and cuts costs. Yahoo! (YHOO) and eBay (EBAY) - Get Report merge. So do Amazon (AMZN) - Get Report and Overstock.com (OSTK) - Get Report.
Private equity is inactive now, and several medium-sized mergers have been announced but few mergers of equals of the magnitude I suggested.
It is hard to see a revival of private equity activity anytime soon.
General Electric is trimming down, but it is not selling NBC Universal.
14. Reversing its recent strength, the U.S. dollar's value falls by over 10% in 2008 (and gold rises to over $1,000 an ounce). Despite the weak domestic economy, foreign reserve diversification efforts and the demand for higher interest rates cause the yield on the 10-year U.S. note to move higher throughout the year.
Our gold and U.S. dollar surprises have already been realized. The yield on the 10-year U.S. note, after declining during the late winter, has resumed its uptrend over the last few months.
A big surprise could be a sharp recovery in our currency in the next few months.
15. The price of crude oil, insensitive to a weakening world economy, eclipses $135 per barrel after an "exogenous" event of terrorism, supply disruptions or political upheaval. The $100 level becomes the new $70! Surprisingly, energy stocks react in a muted fashion to the rip in price as, by midyear, the Democratic Party's populist view of a windfall tax on energy companies gains increased acceptance.
By all measures, these surprises came to fruition.
16. The Internet becomes the tactical nuke of the digital age. The Web is invaded on many levels as governments, consumers and investors freak out. First, an act of cyberterrorism occurs that compromises the security of a major government (similar to the attacks this year emanating from the Chinese military aimed at the German Chancellery) or uses DoS against media and e-commerce sites.Second, a major data center will fail and will be far worse than the 1988 Cornell student incident that infected about 5% of the Unix boxes on the early Internet.Third, cybercrime explodes exponentially in 2008. Financial markets will be exposed to hackers using elaborate fraud schemes (like liquidating and sweeping online brokerage accounts and shorting stocks, then employing a denial of service attack against the company). Fourth, Storm Trojan reappears.
17. The hedge fund community (especially of a quant kind) is disintermediated in 2008. Outflows accelerate, abetting an already conspicuous trend of rising volatility in a market that behaves more like a commodity than ever.
The next shoe to drop is in the under-regulated and over-levered hedge fund industry. After only three months, many hedge funds have already bitten the dust or have been rescued (and shored up) by their parent or sponsoring companies.
18. There are several major Enron-like accounting scandals in 2008, causing investor confidence to plummet. These will come in some large financial and industrial (rollup) companies in Europe and the U.S.
Grade A: SocGen
! And a number of smaller ones, too. And, realistically we could include the parade of financial writedowns in the list of accounting scandals.
I have no view over the next six months on this surprise.
19. Democrats Clinton/Kerrey and Republicans McCain/Crist represent their parties in the presidential/vice presidential contest in November. Ron Paul becomes the Libertarian candidate. In a remarkably close election (reminiscent of the Bush/Gore battle of 2000), the Democrats grab the White House.
The Obama train continued apace, wrecking Clinton's aspirations.
Sam Nunn could be a surprising VP pick for Barack and Crist could lose out to Romney as McCain's running mate.
20. The politics of trade become more fractious (even in the Republican Party) as angst about globalization escalates in the U.S., reflecting inequalities and a cyclical contraction in our domestic economy. Doha dies. And the new Big Things (and the source of liquidity for the capital markets) -- Sovereign Wealth Funds -- become targets of American politicians (and suppress U.S. equities further).
The Democratic Party is talking the trade protectionism book already. The dire straits of the U.S. financial industry suggest that many of these institutions should thank their lucky stars that the sovereign wealth funds (although recently inactive) were there to put their fingers in the dike.
I still believe that the populist movement will gain momentum over the next six months and that both Parties could introduce legislation in support of the U.S. middle class and against globalization trends -- an unfriendly development for the capital markets.
Doug Kass writes daily for
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At the time of publication, Kass and/or his funds were long Citigroup and Bank of America and short Beazer, 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.