This blog post originally appeared on RealMoney Silver on Nov. 1 at 8:55 a.m. EDT.
"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to heaven, we were all going direct the other way -- in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only. " -- Charles Dickens, A Tale of Two Cities
A Tale of Two Cities
, one of only two historical works of fiction written by Charles Dickens. Dickens' novel depicts the plight of the French peasants who were beaten down by the French aristocrats in years leading up to the revolution, the corresponding brutality demonstrated by the oppressed toward the upper class amid the early years of the revolution and the depiction of many unflattering social parallels with life in London during those years.
The idea of the "people" against the "elites" in which social and political system changes occur, embodied in Dickens' work, is a recurring one over the course of history -- and is omnipresent today.
In the broadest sense, as investors in November 2010, we face the best of times and the worst of times.
Above all, the "best/worst" literary metaphor is most apt in the tension between the best of times (the cyclical tailwinds of monetary/fiscal stimulation that have buoyed growth) and the worst of times (the secular headwinds of a number of nontraditional factors that have produced a shallow recovery and that threaten a self-sustaining recovery).
The Best of Times
Today's populism -- manifested by increased activism, distrust in our financial institutions and rejection of the incumbent status quo -- began two years ago with the 2008 Democratic tsunami and has continued with the Republican Tea Party. The midterm elections tomorrow seem likely to produce gridlock, which has traditionally been market-friendly.
The social condition.
The breathtaking growth in the Tea Party signals a growing conservatism in the U.S., an ideology typically associated with a desire for less government spending and for legislation favoring business.
The economy and policy.
- Global coordination: Through a committed all-in central banking community around the world, we avoided an economic Armageddon two years ago.
- Record low interest rates: With short-term interest rates anchored at zero, there are few alternatives for investors.
- Liquidity aplenty: A resolved Fed is promising that liquidity will remain abundant.
- An uptrending economy:: The overall rate of worldwide economic growth, while shallow, remains positive. Over here, the Chicago, Dallas and Richmond PMIs were better than expected last week. Over there, U.K. GDP rose by almost twice the rate of consensus expectations and, overnight, the rate of growth in the China's October PMI quickened to the most rapid pace in six months.
- A likely nadir in the unemployment rate: Future jobs growth, based on improving initial claims data (lowest since July) and a continued improvement in corporate profits, appears likely to improve -- especially within the context of a possible repudiation of the administration's policies in the midterm elections this week (which could serve to reinvigorate business confidence).
- Inflation remains quiescent: Inflation rates remain subdued, owing importantly to minimal gains in the employment cost index. Low wage growth will help to sustain corporate profit margins.
- Housing has bottomed: New-home production continues well below demographic and household formation growth trends, and with mortgage rates at generational lows, affordability at the best gauge in several decades and the benefit of homeownership over renting at 10-year highs, there is an accumulated buildup in latent demand for housing.
- The conditions for a normal and self-sustaining economic recovery are at hand: Interest rates are low, durable expenditures (automobiles and housing) have been deferred, and the unemployment rate has likely bottomed. The consensus of forecasters for a moderate improvement in economic growth is a conservative one.
- Valuations are not rich: The U.S. stock market's valuations (at around 13x) remain below the historic mean (15.5x). When placed against the currently low level of inflation and interest rates, share prices are even cheaper.
- Return expectations and individual investor participation are low: While slowly building in the near term, multiyear individual inflows into domestic equity funds has been limited, providing the potential for greater equity buying power (and interest) in the years ahead.
The Worst of Times
It can be argued that the likelihood of gridlock in the aftermath of this week's midterm elections is not a P/E-expanding event, as the significance of our fiscal challenges (local, state and federal) and the currently weak domestic economic growth trajectory need to be quickly addressed. Moreover, the politics and policy of populism will remain with us for the foreseeable future and, with it, is the continuum of higher marginal tax rates for the wealthy and the burden of costly and cumbersome regulation (after years of laissez faire attitudes regarding policy within our regulatory agencies).
The social condition.
Our Dickenesque condition of social inequality remains in the forefront of the political tide and future. The contempt for the wealthy and large corporations could be manifested in continued initiatives aimed at increasing upper-income earners' tax rates and in reducing corporate profitability (through increased taxes and the costs of heightened regulation).
The economy and policy.
- Lack of global coordination: Conditions are far different for QE 2 than QE 1. Unlike QE 1, when the world's central banks were all-in. U.S. policy makers are a bit on their own this time, as other areas of the world reject more massive monetary responses in favor of dealing more directly (and urgently) with their own fiscal imbalances. QE 2's impact remains uncertain, and the unintended consequences of more easing pose additional risk (e.g., the CRB hit a two year high on Friday).
- A cyclical low in interest rates is at hand: Interest rates have already fallen to very low level, but while anchored at zero, they cannot go lower. Moreover, nearly every cycle characterized by the search for yield (as investors buy almost any long-dated asset) has backfired historically. Finally, any evidence of rising inflation (which we have already seen in feedstock and in food inputs) will incite the bond vigilantes and cause interest rates to resume their climb. (I continue to view shorting bonds as the trade of the decade.)
- Late in the liquidity game: By most measures, it is growing late in the liquidity game, and the cost and consequences of imbalances created by fiscal/monetary stimulation are ever closer at hand. Meanwhile, our fiscal imbalances multiply, our currency craters (as a worldwide rush to currency devaluation is offsetting some of the normal trade-deficit benefit), and the bulls rationalize these concerns by suggesting that the consequences "are beyond our investment time frame."
- Anemic economic growth poses inherent risks to its sustainability: The shallow domestic economic recovery is vulnerable to policy mistakes, a drop in business/consumer confidence and other unknown and exogenous variables. Meanwhile, the rate of sales growth is already beginning to decelerate and screwflation threatens record high corporate profit margins.
- Unemployment will remain elevated: The jobs picture is likely to be mired by a structural deterioration in employment and the continued propensity to hire on a temporary basis in the face of higher costs and more regulation. Limited wage growth and sour consumer confidence -- last week the University of Michigan Index dropped to its lowest level in a year -- will constrain personal consumption expenditures.
- The large productivity gains of the last decade are over: With average weekly hours worked stretched to the upper limits, most of the impressive productivity gains of the past few years seems over, as increased hirings are likely to negatively impact profitability.
- Housing's rebound will be muted: Weak confidence and a poor jobs market coupled with the surprisingly large drop in home prices will undermine the housing recovery. Mortgage-gate threatens the rebound in housing by signaling a deluge of unsold shadow inventory in 2011 and another possible fall in home prices.
- Tail risks: The long tail of the last credit cycle promises to show up in new quarters over the next one to two years. Mortgage-gate was a recent example of that tail. Odds favor more -- both here and abroad.
- It's different this time: The residue of the last cycle also brought with it a number of nontraditional headwinds that will continue to serve as a governor to economic growth (higher marginal tax rates, local, state and federal fiscal imbalances, more costly and burdensome regulation etc.). If gridlock means kicking the legislative can down the road until the next Presidential election and avoiding the necessary fiscal focus that would remedy the poor jobs picture, the self-sustaining economic thesis will be in jeopardy.
- The market rally has been the world's fair: Equities are substantially off the generational low of March 2009 - as the better-than-expected recovery in corporate profits appears to have been materially discounted. Meanwhile, market leadership appears to be narrowing and market volume is tepid.
- Sentiment measures ebullient: Certain measures of investors' sentiment (AAII and Investors Intelligence) are back to levels that have typically existed at market tops. Another contrarian sign? The cover of Barron's this weekend is entitled "Bye-Bye, Bear."
Time and Tide Waits for No Man
"The water of the fountain ran, the swift river ran, the day ran into evening, so much life in the city ran into death according to rule, time and tide waited for no man, the rats were sleeping close together in their dark holes again, the Fancy Ball was lighted up at supper, all things ran their course." -- Charles Dickens, A Tale of Two Cities
Implicit in some of the market rise over the last few months is the view that the tension described in today's opening missive will almost certainly be resolved favorably after the outcome of the midterm elections and the scope of quantitative easing are determined this week.
I am less certain.
When I weigh the body of the best and worst of times, I anticipate a government divided (what was described on "Meet the Press" yesterday as an "unearned" win by the Republicans in the House and a continued Democratic majority in the Senate) and few net benefits from QE 2 (and some adverse unintended consequences from further easing).
I continue to
that the U.S. stock market has seen the top for the year, and I envision a relatively narrow trading range with a slightly negative bias over the balance of the year.
Looking ahead to early 2011, as the market braces for gridlock and more economic uncertainty and challenges, I expect the current optimism to diminish and for equities to succumb to the grimmer reality of slowing, uneven economic growth prospects, the challenges of nontraditional headwinds and a divided U.S. government unable to address key issues and imbalances.
Doug Kass writes daily for
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Doug Kass is the general partner Seabreeze Partners Long/Short LP and Seabreeze Partners Long/Short Offshore LP. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.