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Kass' Top 25 Surprises: How Am I Doing?

A look back at a list of predictions shows many right calls.
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Editor's Note: This blog post originally appeared on RealMoney Silver on Aug. 6 at 8:30 a.m. EDT. Check out James Altucher's take on Kass' 25 Surprises.

It has been seven months since my

surprise list

for 2007 was written, so it's time to review how accurate I was.

But first, how I go about my list. Taking a page from former Morgan Stanley strategist Byron Wien, now the chief investment strategist at Pequot Capital Management, every December I 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. 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.

(James Altucher took a look at my surprise list and added his

two bits

, and I look forward to his update.)

About one-third of 2006'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

.

Thus far, my surprise list for 2007 hit the bull's-eye more than in any other year in identifying the key issues that investors have faced -- the credit squeeze, the liquidity squeeze, the subprime crisis, the depression in housing, and rising market volatility.

With the benefit of hindsight, the December 2006 column might have been the most valuable contribution that I have made since I started writing for

TheStreet.com

seven years ago. This is why I write the column every year. It helped me to tackle the coming year, and I hope it helped you avoid some major market potholes.

My major surprises (considered outliers seven months ago) came home in spades, particularly No. 5 and No. 6, in which I cite that a major investment bank, heavily involved in fixed-income trading, faces monumental losses and a debt downgrade. Hello,

Bear Stearns

(BSC)

. As Grandma Koufax used to say, "Dougie, you were right for the right reasons."

While the year is still young, what follows is a review of my surprise list for 2007 -- with grades.

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 Goldman Sachs Group, Inc. (GS) Report

acquires

Texas Instruments

(TXN) - Get Texas Instruments Incorporated Report

. Kohlberg Kravis Roberts leads a syndicate in the takeover of

Caterpillar

(CAT) - Get Caterpillar Inc. Report

(CAT), 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 CBS Corporation Class B 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.

    Grade:A+. While I was wrong on the names, note the last sentence in the first surprise. Back in December 2006, not a soul even considered the possibility that the capital markets would seize up. The credit crisis emanating from the subprime disaster is the financial story of the year.

2.

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

Citigroup

(C) - Get Citigroup Inc. 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).

    No Grade: The jury is still out.

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.

    Grade:A+. Both former Fed Chairman Greenspan and current Secretary of the Treasury Paulson forecast stabilization/bottoming in the housing market. Homebuilding stocks made yearly highs in late-May.

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 2000-2006" after years of creative but nonsensical low or nondocumented lending behavior.

    Grade:A+. In both timing (spring) and magnitude, the wheels fell off housing. The Great Housing Depression of 2007 began apace, and the mortgage lenders/originators have fallen in a dramatic fashion.

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.

    Grade:A+. The credit problems (subprime contagion, exploding credit spreads) have morphed into both an economic and stock market event.

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 JPMorgan Chase & Co. (JPM) Report

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

    Grade:A++. While the JPM rumor has not yet occurred, I hit the nail on the head on this one, as BSC's debt has been downgraded recently.

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.

    Grade:A+. As sure as night follows day, the government will shortly get into the act. Equally likely is a Fed rate cut.

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.

    Grade:B. Commodity prices did break earlier in the year (and will likely descend now in the face of the credit pressures). And we are about to experience a deflationary scare. Interest rates, however, remain elevated.

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.

TheStreet Recommends

    Grade:B-. I nailed first-quarter 2007 profit growth but was dead wrong on the quarter that ended June 30, 2007. I am reasonably certain my second-half corporate profit growth forecast will be prescient.

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.

    Grade:A+. Right on cue.

11.

Stocks begin 2007 the way they ended 2006 -- very strong -- and the S&P 500 temporarily breaches 1,450 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 1,250, 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 Microsoft Corporation (MSFT) Report

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

    Grade:A. Stocks began the year strong, but it was only until recently that equities have been pressured. Junk bonds are a disaster. (The volume of new high-yield bonds fell by 90% in July.) The market for loans to highly leveraged companies has almost dried up. Standard & Poor's counts $35 billion in corporate loans that have been delayed or canceled. Mutual fund investors have been pulling back rapidly, with more than $1.3 billion coming out of funds that invest in leveraged loans during recent weeks, and $2.7 billion leaving funds that buy high-yield bonds, according to AMG Data Services. However, technology stocks continue to show excellent absolute and relative performance.

12. Fidelity Management

announces the introduction of its first dedicated short equity product.

Alliance Capital

follows with a similar product shortly thereafter.

    Grade:C. Nope (thank goodness!).

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.

    Grade:A+. Private equity deals have slowed to a crawl and my expectation for REITs turned out to be accurate. (See this weekend's comments I had in Barron's.)

14.

A well-known corporate raider finds himself with a concentrated portfolio of illiquid investments and suffers large losses. ESL's Ed Lampert cagily watches the early year private-equity euphoria and does nothing, opting to shore up his liquidity. But as equity prices drop in the second half, he is joined by several previous corporate partners in making a large acquisition in the entertainment/media field by year-end.

    No Grade: I still suspect a large activist investor is going to be caught with large losses in the current market drop.

15.

America's growing dependency on convergence and connectivity (computers control power delivery, communications, aviation and financial services) becomes a battleground and launching pad for a series of

cyberterrorism

acts by a terrorist group in early 2007.

The first few virtual attacks are ignored and have no effect on the market or on the Internet. However, during a chaotic weeklong period after the July Fourth holiday, an attack renders the Internet partially ineffective, threatening to eradicate crucial information storage bases and to stop commerce and communication.

    Grade:F.

16.

There are several political surprises in 2007. Most significant is that New York Sen. Hillary Clinton, citing personal issues, announces that she will not run for the Democratic presidential nomination in 2008 and that she will throw her support to former Vice President Al Gore's candidacy. Democratic hopefuls Barack Obama, John Kerry, Evan Bayh and Joe Biden do not pursue the nomination, leaving Senator John Edwards as Gore's only viable competition.

On the other side of the ledger, Newt Gingrich is an early aspirant to the Republican nomination and, surprisingly, is in a dead heat in early polls against the favorite, Sen. John McCain, with Mitt Romney and Condoleezza Rice far behind. Rudy Giuliani does not enter the race after a

New York Times

investigative report uncovers some questionable business dealings.

    Grade:F.

17. After New York Yankee baseball team owner George Steinbrenner falls seriously ill, SAC Capital Partners' legendary Steve Cohen acquires a majority control of the New York Yankees and, at year-end, retires from active management at his hedge fund.

    Grade:A+. The New York Postreported this week that Steinbrenner's health has deteriorated and on Saturday that the sale of the New York Yankees could be imminent.

18. Wal-Mart

(WMT) - Get Walmart Inc. Report

fails to come out of its funk and reports five consecutive months of negative same-store sales. Overall retail spending follows the housing decline and briefly falls to levels that haven't been seen since the last recession as consumer confidence drops to lows not seen in more than 15 years. Purchases of discretionary items such as motorcycles, high-end kitchen appliances and jewelry suffer.

    Grade:A. WMT's comps have been dismal. Retail sales are disappointing and trending lower. Consumer bankruptcies rose by 34% last month.

19. Google

(GOOG) - Get Alphabet Inc. Class C Report

marches on, proving its skeptics wrong, and dramatically exceeds sales, profit and cash-flow expectations. Its shares approach the $650 level by early spring, after rising by more than $100 the day after first-quarter earnings are announced. Though results continue to beat expectations in the second and third quarters, the shares take a large hit after its domination and monopolistic position in search is questioned by legislators in a series of congressional hearings later in the year.

    Grade:F. I was flat out wrong.

20.

Saddam Hussein is assassinated in jail even before his appeal is concluded. Osama Bin Laden is found dead, and initial reports indicate he has been dead for more than 12 months.

    Grade:F.

21.

A series of corruption scandals in Russia hits the emerging markets in 2007, which further exacerbates the impact of uneven worldwide economic conditions and difficulties in the mortgage markets.

    Grade:F.

22.

A large hedge fund lowers its investment management fees (to 0.5%) and incentive fees (to 10%). This effort, combined with the overall market weakness in 2007, leads to a 50% reduction in the number of hedge funds over the next 12 months.

    Grade:B+. The disintermediation of hedge funds appears to be a second-half 2007, early 2008 event.

23.

With the hedge fund ranks diminished, commodities dropping in value and the appeal for alternative investments (private equity, real estate, etc.) moderating, the bullish chorus for a global liquidity case for equities becomes a faint whisper.

    Grade:A+. Enough said.

24.

Maria Bartiromo leaves

CNBC

to join Joy Behar, Rosie O'Donnell and Barbara Walters on

ABC's

"The View."

(At the same time, Elisabeth Hasselbeck gets booted off the show!) Another well-known

CNBC

anchor leaves to join a large hedge fund.

    No Grade: But I would make a bet that Maria shortly signs a multimillion-dollar contract to head up the News Corporation (NWS) business channel.

25.

Amid the early 2007 stock market euphoria, Jim "El Capitan" Cramer's "Mad Money" show goes prime time on

CBS

. But it is canceled during the midyear market meltdown and returns to

CNBC

by the fall.

CNBC

extends the show to two hours by year-end after

Cramer, The Movie

reaps $38 million in its first weekend.

    No Grade.

Check out James Altucher's take on Kass' 25 Surprises.

At time of publication, Kass and/or his funds had no positions in stocks mentioned, 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 $6 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."