) -- Doug Kass of Seabreeze Partners is known for his accurate market calls and keen insights into the economy, which he shares with

RealMoney Silver

readers in "The Edge," his daily trading diary.

This week, he wrote about the swelling downside risk for equities, what bank stocks need to make sustained gains and what his favorite long and short stock bets are.

Also this week, Kass

recounted the return of daytrader Boca Biff



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Risk to the Downside Grows

Originally published on Oct. 11 at 8:20 a.m. EDT.

Given the sharp rise in equities, the downside risk may soon lie at the highest level in a year.

Investors and traders are cheering for more bad economic news so, as the logic goes, the Fed must monetize more assets, even though the strategy has been innocuous. This is like Detroit Lions fans cheering for losses so they can get another high draft pick, even though they have been getting high draft picks for years, and it has had no beneficial effect for the team.-- Bill King, The King Report

As we begin the final quarter of 2010, let's start by reviewing how both the bulls and the bears have erred in their strategic visions for this year:

  • The bulls have underestimated the ability of the U.S. economy to sustain growth without an extreme Fed makeover and did not foresee the continued contraction in P/E multiples. Current low levels of manufacturing capacity utilization rates and an elevated unemployment rate were not in the bulls' playbook a year, six months or even three months ago.
  • The bears have underestimated the extent to which investors would go along with the Fed's ride and were willing to believe that the government can stimulate growth allowing the cycle to become self sustaining.

In a






quantitative easing

, I have


the ultimate efficacy of further quantitative-easing measures. While the first round of quantitative easing produced "shock and awe" two years ago, QE 2 will likely produce "shucks and aww."

Most market participants are fixated with the potential for QE 2 to boost asset prices and generate organic economic growth, however, without a subsequent rise in aggregate demand and productivity, the program will ultimately be deemed a failure as prices readjust over time to reflect the real underlying fundamentals. Mr. Bernanke is making the same blunder that we made with the past bubbles busts -- if we can create paper profits and convince consumers that they should spend those paper profits, then we'll be on our way to economic prosperity. The problems arise when asset prices readjust lower to meet their true fundamentals. It's Ponzi finance and nothing more.As I have previously explained, the goal of QE is to increase aggregate demand by creating a fictitious wealth effect and by increasing bank loans. The market appears to think that QE 1 was some sort of success, but as I have argued, QE 1 was only successful because it altered bank balance sheets and alleviated the credit strains. After all, this was Ben Bernanke's goal at the time -- to alleviate the credit pressures. What QE 1 did not do (and what we need now) is increase lending supported by a boost in real aggregate demand. QE does not add net new financial assets to the private sector and is not inherently inflationary, though Mr. Bernanke appears to be convinced otherwise. Unfortunately, QE 1 failed to succeed in contributing substantially to the economic recovery as Northern Trust recently showed.-- " Northern Trust: QE 1 Failed, Why Will QE 2 Work?" from Pragmatic Capitalism

QE 2 (quantitative wheezing?) will not meaningfully move the needle of domestic economic growth and will only have a limited impact on:

  • the jobs market, which is plagued by structural unemployment;
  • housing, which that is haunted by a large shadow inventory of unsold homes and in which mortgage credit will likely be further reduced by the moratorium on foreclosures; and
  • confidence, which is still mired in uncertainty regarding regulatory and tax policy (and that is undermined by high unemployment).

Meanwhile, our fiscal imbalances multiply, and our currency craters (and a worldwide rush to currency devaluation offsets some of the normal trade deficit benefit). There are a number of other possible adverse consequences from the inefficient allocation of resources that is the outgrowth of the next tranche of monetary stimulation.

The Federal Reserve seems determined to make mistakes. First, it started rumors that it would resume Treasury bond purchases, with the amount as high as $1 trillion. It seems all but certain this will happen once the midterm election passes. Then, the press reported rumors about plans to raise the inflation target to 4% or higher from 2%. This is a major change from the Fed's quick rejection of a higher target when the International Monetary Fund suggested it a few months ago.Anyone can make a mistake, but wise people don't repeat the same one. Increasing inflation to reduce unemployment initiated the Great Inflation of the 1960s and 1970s. Milton Friedman pointed out in 1968 why any gain in employment would be temporary: It would last only so long as people underestimated the rate of inflation. Friedman's analysis is now a standard teaching of economics. Surely, Fed economists understand this.Adding another trillion dollars to the bank reserves by buying bonds will not relax a constraint that is holding back spending. There is no shortage of liquidity in the economy -- banks already hold more than $1 trillion of reserves in excess of their legal requirements, and business balance sheets show an unprecedented amount of cash and near-cash assets. True, increasing bank reserves means mortgage rates will decline, at least temporarily; they already have in anticipation of the bond purchases. But neither the Fed nor the public should expect much stimulus as a result.The most important restriction on investment today is not tight monetary policy but uncertainty about administration policy. Businesses cannot know what their taxes, health care, energy and regulatory costs will be, so they cannot know what return to expect on any new investment. They wait, hoping for a better day and an end to antibusiness pronouncements from the White House. President Obama could do more for the economy by declaring a three-year moratorium on new taxes and new regulation.-- Allan Meltzer, The Fed Compounds Its Mistakes, Wall Street Journal (op-ed)

The U.S. economic recovery remains fragile and is still characterized by excess industrial capacity and a surplus of labor. If we were in a sound and non-jeopardized economy, the Fed would not be having a QE 2 discussion nor would the administration be seeking extreme fiscal solutions. In my view we are in a contained recession, and while containment efforts continue, the efficacy of these efforts now appears to be waning.

While the immediate response to the likelihood of QE 2 has been to buoy asset prices, the domestic economy is stalling at around 1.5% to 2.0% GDP growth, and little improvement in the jobs market has been made. This hesitancy makes the slope of the recovery vulnerable to the unforeseen --

trade wars

, policy errors and/or numerous tail risks from the last credit cycle (e.g., mortgage-gate).

To be balanced, I recognize that there are a number of factors that will insulate stocks from a meaningful drop. Among the positive considerations is that most discounted dividend models indicate value in equities (as interest rates are anchored at zero). Large corporations are flush with cash, are operating at record profit margins and face an inexpensive and hospitable bond market, which is supporting good dividend growth and robust buyback activity. Allocations into equities by institutional and retail investors remain muted. And, with mortgage rates plummeting, the consumer's debt service and balance sheet has improved more rapidly than anticipated.

Nevertheless, as I have written previously, I continue to see the risks to 2011 corporate profit and U.S. and worldwide economic growth rates to the downside. It remains likely that secular and nontraditional headwinds will produce an extended period of inconsistent and uneven growth in the years ahead -- difficult for both corporate managers and investment managers to navigate. Arguably, given the sharp rise in equities, the downside risk might be growing ever greater and may soon lie at the highest level than at any time over the last 12 months, especially if I am correct that QE 2 will be a dud.

Banks Mixed

Originally published on Oct. 13 at 11:14 a.m. EDT.

I can't see the group making a sustained advance until there are signs of expanding loan demand.

Banks are mixed after

JPMorgan Chase's

(JPM) - Get Report


While the credit quality trends remain in place, I can't see the group making a sustained advance until there are signs of expanding loan demand.

Favorite Long and Short

Originally published on Oct. 12 at 11:18 a.m. EDT.

Favorite long:

American Express

(AXP) - Get Report


Favorite short:


(FAST) - Get Report


At the time of publication, Kass was long AXP and short FAST.

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.