This blog post originally appeared on RealMoney Silver on Jan. 22 at 7:49 a.m. EST.

Notwithstanding the attempts by many to marginalize the role of the U.S. economy on worldwide economic growth, most of the world's economies will soon feel our pain.

That bullish cabal (especially of a Ben Stein kind) will recognize the existence of the downturn only after the fall in equity values (and after digesting the conclusive economic evidence that is forthcoming) -- in other words, after it is too late to prepare investors.

Note: I am hard on the permabulls because they were hard on me over the last 12 months. I will continue to take the high road, however, by not mentioning any of the names of that dogmatic constituency -- with the exception of the Bens, Stein and Bernanke -- whose economic heads and market "wisdom" have been firmly implanted in sand.

The short-term economic outlook is now practically cast in stone, and the sharp downturn in equities will only serve to exacerbate the growing economic weakness and loss of confidence on the part of consumers and businesses.

Expect market assumptions for retail sales, business spending and, most importantly, corporate profits to be ratcheted down in the weeks ahead.

In order to properly navigate the investment terrain, investors must answer the following five critical questions:

    1. How long will the recession last?

    2. How deep will the recession be?

    3. How will corporate profits be affected?

    4. What will the response be in the capital markets?

    5. What wild cards could change the economic and capital market backdrop?

What follows is a summary of my conclusions, and these conclusions will serve as a blueprint for my overall market views and attendant investment strategies.

How Long?

Most recessions are relatively brief -- under a year in duration. The evolving supercycle of credit availability (mainly through securitizations) over the last decade, coupled with its unique profile/character of egregious risk-taking as seen from the eyes of both creditors and borrowers, is unlike any cycle in modern financial history. Problems in the residential real estate category have spread like a wildfire throughout the broader economy, putting a pinch on the banking system and, in a marked reversal, serving to restrict credit to many borrowers.

Corporations of all kinds now face a closed window of credit securitizations, so American industry's ability to grow lies squarely on direct bank lending. Unfortunately, with money market rates at 2.75%, the 10-year Treasury note at 3.55% and the federal funds and discount rates at 4.25% and 4.75% respectively, banks have little incentive to lend -- especially in a questionable economic setting.

The securitization market is broken and will take years to repair. Accordingly (and subject to the magnitude of the negative wealth effect of the eventual stock market hit), the 2008-2009 recession will likely be deeper and lengthier than those of the past. Even more important, the aftermath of the recession will be lingering, producing a period of inconsistent and uneven growth, and difficult for corporate managers and investment managers to navigate.

How Deep?

Despite the current appearance of a tardy and timid Fed and a generally unresponsive and unimaginative administration, fiscal and monetary stimulation will be swift in its implementation and will, in the fullness of time, buffer somewhat the magnitude of the falloff in GDP. More aggressive policy moves could be hastened by the proximity of the presidential election in November 2008.

Impact on Corporate Profits?

A profit drop of about 10%, skewed (and deepening) toward the second and third quarters, is about what we should expect in 2008. Mitigating against some of the profit pressure will likely be a reasonably swift decline in commodity prices (especially of an energy kind) and still historically low interest rates. Nevertheless, corporate pricing power will not likely stabilize until well into 2009 (at the earliest), so corporate profits in 2009 will likely be flat to up 5%, well below market expectations.

Response From Capital Markets?

As we have seen in January, markets see through and quickly reject incessant cheerleading (especially in the media). With Monday's collapse, most of the fall in the stock market and the rise in the fixed-income have probably already occurred in an environment that, more than ever, adjusts so rapidly to changing economic conditions.

A possible explanation for this phenomenon is that the dominant investors today (i.e., the world's hedge funds) move more swiftly than the dominant investors of the past (i.e., bank trust departments in the 1970s and mutual funds in the 1980s and 1990s) -- and so do individual daytraders. Another possible explanation is that the Internet platform and other communication devices provide an almost instantaneous information flow.

As mentioned earlier, the economic choppiness will produce abrupt market moves to the downside and the upside, which will be difficult to navigate but ideal for the opportunistic investor. Permabulls, permabears and trend-followers will be frustrated, but those who remain market-agnostic and sell the rips and buy the dips could be rewarded.

Possible Wild Cards?

On the negative side, more worldwide stock market weakness (reinforcing the existing economic vulnerability), tardy and indecisive policy decisions (both monetary and fiscal), another leg down in the housing market, any event that further seizes up the credit markets and a sharp rise in energy product prices could all prove to have a disruptive effect on the economy and markets.

On the positive side, a decisive move to insure and underwrite counterparty risk by the administration would serve to stabilize the mortgage, bond and other credit markets and could produce an immediate and immensely positive impact on stocks around the world. As well, a more aggressive easing than is generally anticipated by the Federal Reserve could have a salutary impact on equities and business conditions.
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.

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