This blog post originally appeared on RealMoney Silver on Dec. 4 at 9:01 a.m. EST.
Before my critics dismiss out of hand what appears to be an abrupt turn of market judgment and suggest that I am simply reverting to my permabear leanings, today's opening missive will try to explain why the investment mosaic seems to be deteriorating rapidly.
No Memory From Day to Day
First, let me digress and frame the sort of current (and continuing) market in which I see us -- a market with limited memory from day to day. In a period of substandard returns, which I believe we will be in for an extended period of time, gaming 5% moves (up or down) will remain an important ingredient in delivering superior investing/trading results.
As I mentioned on my year-end rally call, most investors should remain market agnostic, as only the most facile can game abrupt short-term moves (even of 5%). Importantly, rather than viewing these moves as the start of a primary trend, investors might best be served to continue the pursuit of both long and short opportunities -- and they should remain skeptical on the initiation of meaningful trend moves higher in a market without memory from day to day.
With this in mind, I had sound reasons for expecting a
(which managed to produce a near 5% move up from Monday's close to Friday's close). My expectation was based on the perception that the market was getting its arms around some of the credit problems as financial institutions became less opaque and more forthcoming, the administration was planning for a mortgage bailout, November and December are historically periods of strong seasonal strength, the political landscape was changing (in favor of the Republican Party), and we were at an apparent negative sentiment extreme.
My year-end rally call, while predicted at slightly higher levels than where it started, was in munificent form between Tuesday and Friday of last week.
At the Doorstep of a Recession
It is now, however, again time to sound an alarm, principally because we have alleviated some of the market's oversold condition, the corporate profit outlook has deteriorated further, the credit crisis remains intense (and is probably only in the fourth inning), the subprime bailout proposed by the Treasury is likely to face obstacles, and poll results suggest that the surge in the Republicans' political recovery might have stalled.
Above all, the drop in real consumer spending, the weakening household survey of jobs (and the rise in jobless claims), the dire outlook for construction spending, plummeting consumer confidence (in line with the poor data experienced during the business contractions in 1991 and 2001), the negative Chicago Fed activity reports (negative for the last three months) and beige book indications all suggest that fourth-quarter 2007 growth will be under 1% -- and that, as of early December, the U.S. economy is probably exhibiting no growth.
Slowly, economic bulls such as Miller Tabak's Tony Crescenzi, Bear Stearns' David Malpass and
my friend/buddy/pal Larry Kudlow are abandoning their most optimistic outlooks. Late last week, Mother Merrill's David Rosenberg took a knife to his 2008 profit forecast. Rosenberg now sees a 7%
in earnings compared with a consensus 12%-plus
. If you read just one piece of research for the rest of the year, please read
. (Goldman Sachs seems close behind in its revisionist views). While Merrill Lynch's and my earnings outlooks remain outliers, I fully expect others to follow (but probably when it is too late).
Mean Reversion Has Begun
In the third quarter of 2007, we learned that the U.S. can be in a profit recession (down 8% year over year) even though GDP rose by about 5%. It is very worrisome to consider how deeply profits might contract if the economy slows down to 1% growth in the fourth quarter of 2007 and possibly declines in early 2008.
I believe the domestic economy is now in (or close to) a recession, and the effect of the post-bubble deleveraging and contraction in supply and demand for credit has just begun. Even if a recession is avoided and the U.S. dollar promotes continued export growth, the mean regression of corporate profit margins (fueled by tepid top-line sales growth, rising costs and eroding credit quality) seems likely to provide a significant headwind to stock prices as pricing power dwindles. Importantly, in the fullness of time, this profits slowdown/decline also will lead to a decline in business spending -- a mainstay to the bullish argument.
'Play With Pain?'
Now let me make some additional responses to some things that have changed and tell you why Jim "El Capitan" Cramer's clarion call to "play with pain" might be harmful to your financial health.
Investor optimism over an anticipated Fed cut in December seems misplaced
devotees were out in full force last week as the slightest hint of confirmation of a rate cut spurred a euphoric market response, even though the fed funds futures market had incorporated the cut for weeks. The reality is that the last two rate cuts failed to revive the economy -- indeed, conditions have worsened.
As well, credit markets have tightened. The TED spread (the difference between the T-bill interest rate and the U.K. Libor (London interbank offered rate)) has widened to over 210 basis points and stands at a level not seen since 1987, and the three-month Libor) has risen for 11 out of 12 days -- at 5.15%, it is 25 basis points above the mark at the last Fed easing.
Cramer believes that "playing with pain" (and bad news) is appropriate, as the market is a discounting mechanism, and Fed moves have a six- to 12-month delay in their effect. Where I disagree is that, at best, it will take an enormous amount of easing to get the same amount of economic growth as in the past, and with it will come the unintended consequences of a falling U.S. dollar and higher inflation.
At worst, I see the Fed pushing on a string, as today's economic problems will likely prove relatively insensitive to rate reductions (given a continuation of constrained credit). Indeed, as mentioned previously, six to 12 months from now, I expect the fundamentals (read: corporate profits) to have materially eroded from current levels.
The financial sector represents poor market leadership as it appears early in the group's profit downturn
. The rally was led by the hapless financials, which lie at the epicenter of the financial system's credit problems. I remain of the view that financials are value traps, and I am short a long list of them. My negative view of the financials runs deep and was
in this weekend's
. The major flaw in the renewed interest in financials is that their secular growth prospects have been radically impaired.
- The prosperity of the past decade in the financial sector cannot be duplicated; it was an illusion of extraordinary gains that were the outgrowth of a cycle of unprecedented credit/debt creation that produced enormous profits in originating, packaging and trading in a wide range of derivative products as well as benefiting from a simultaneous advance in nearly every asset class (bonds, equities, private equity, commodities, residential/non-residential real estate markets, etc.).
- In the third quarter of 2007, the banking sector experienced a 25% reduction in earnings. Loan losses surged by 120% (to the highest level in 20 years), and delinquencies and foreclosures accelerated as the inventory of unsold homes is at a multidecade high.
- In a maturing world economy, consumer/business losses will rise as the credit loss experience (so favorable in the last decade) regresses to the mean. And the vulnerability of near historically cycle low loan-loss reserves will be exposed.
- The subprime writedowns represent a permanent loss of financial industry capital. More fourth-quarter writedowns are coming at Morgan Stanley (MS) , Merrill Lynch (MER) , Citigroup (C) and others. Remember, every $1 lost in money heaven means that $10 to $15 of earning assets (loans and investments) must be reduced to conform to capital requirements. As such, credit availability will continue to be constrained for years to come.
- At the margin, replacing lost capital will be costly. For example, Citigroup paid 11% to Abu Dhabi for its injection of $7.5 billion early last week.
- There is a lot of credit "stuff" still in orbit above the banking industry's balance sheets, and taking them back and "boarding" them back on their balance sheet is increasingly likely.
- The consensus for 2008 financial sector profits growth is for a rise of about 15%. By contrast, it is my view that financial sector results could drop by as much as 10% next year.
We are receiving a clear recessionary message from fixed income.
on "Kudlow & Company" on Friday evening, the conflict between equity and fixed-income performance remains unresolved as stocks are signaling the likelihood that the Fed may have a positive effect on growth and bonds are repudiating the pro-growth view. I continue to believe that fixed income has a Wharton MBA and usually "gets it" better than its equity counterpart, which too often acts more like a failing student at Nassau Community Junior College. In that regard, the message from the 3.85% yield on the 10-year U.S. note is crystal clear: We are recession-bound.
The mortgage bailout is going to be messy, complicated and difficult to effect
. The proximate cause of Friday's market advance appeared to be the notion that the subprime crisis will finally be resolved by policy fiat. The decade-old slicing and dicing of mortgages into securitized and derivative products, however, is one of a number of substantive legal, technical and mechanical challenges to the administration's policy initiatives toward successfully stabilizing the mortgage markets. In the week ahead, I will expand on why I am skeptical of a positive outcome, which seems destined to not only prolong the agony of housing's down cycle but could also face political gridlock.
The technical position remains problematic
. A lot of the oversold condition(which formed the basis for a year-end rally) was corrected in last week's rally, but the broader picture of a market top remains in place. It is not written in stone that we have to return to an overbought condition before turning lower. Indeed, many bear markets are in oversold for extended periods of time. Meanwhile, while two days does not a trend make, technology abruptly began to underperform last Friday, and the weakness continued yesterday. This is never a good sign. And should the renewed strength of the U.S. dollar continue for a while, coupled with the possibility of a consumer slowdown, then technology, the lifeblood of nearly every bull market, might lose its technical and fundamental moorings.
The Republican challenge seems less formidable than two weeks ago
. Here is a
Real Clear Politics
polls that show a recent flattening in the Republican Party's recovery and a stabilization in the Democratic Party's popularity. After watching "Meet the Press" on Sunday, it seems this change might be a function of a firming Clinton lead and a confusing Republican nominee picture caused by a combination of Huckabee's quick rise and reports of questionable expenses and other morality issues in the Giuliani campaign.
Moreover, the second chart in the
Real Clear Politics
link demonstrates that individual news polls point toward renewed strength in the Clinton presidential campaign over any Republican. Remember that any further evidence of a resumption of the Democratic tsunami brings with it the politics of trade protectionism and concerns regarding higher tax rates for individuals and for corporations.
Keep Your Eyes Peeled
Above all, we should keep our eyes and ears open. Whether right or wrong in my market view, I am always committed to explaining my analysis and investment rationale. And that view remains that the world equity markets have not priced in the ramifications of a materially adverse change in credit supply and availability as well as the growing probability of an economic and profit recession in the U.S.
At time of publication, Kass and/or his funds were short Morgan Stanley, Merrill Lynch, Citigroup, PowerShares QQQ and SPDRs, 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.