This blog post originally appeared on RealMoney Silver on June 2 at 7:57 a.m. EDT.

I have been struck by the degree of group divergence over the last three months, 12 months and 24 months. It seems to this observer that, more than almost any market time frame in recent history, industry sector selection has never been more important in delivering superior investment returns.

The past repeats itself (almost constantly), momentum is your friend, don't fight the tape, buy strength, etc. are repeated slogans that, almost by definition, yield superior results. The temptation to go with the momentum remains strong in life and in markets, but, at some point, if the majority confidently knows something, that something is probably already reflected in the price.

History teaches us investment lessons, but it fails to tell us which lesson should be applied and when it should be adopted. The biggest problem I have as an investor is farsightedness (in expecting the unexpected), and I see the biggest problem with most investors as shortsightedness.

Keeping My Money in the Banks

The financial future may be imagined, but it can never be absolutely known, which brings me to the bank stocks.

Contrarian bets that ignore the trend (like shorting housing-related securities two or three years ago) often yield large rewards. Bank stocks have never been so cheap, and, in the fullness of time, long positions could be rewarded.

As lynx-eyed Dick Bove remarks in his research missive over the weekend, "the situation is simply not as bad as it appears." Dick, who I have known personally for over 30 years and who I admire, makes the following points in his piece, which is entitled, "Bank Stocks Are in Free Fall, but Banking Companies Are Not."

    1. Banking cash flows signify the industry's health, and the signs are positive:

  • common equity builds;
  • reserve builds; and
  • deposit flows.
  • 2. Like all companies, growth in unit sales at healthy margins determine secular profit growth:

  • Market share shifts benefitting unit sales for core group of industry leaders; and
  • margins are stable but are about to rise.
  • 3. Bank cash flows are adequate to allow these companies to pay and increase their dividends.

    4. Loan losses and security writedowns are cyclical, not secular, phenomena.

    5. Disparity between stock prices and industry health creates investment opportunity.

    6. The catalyst that will turn bank stocks up at this point is unknown, but by one measure, core bank earnings power is near its peak.

'Blahflation' Around the Corner?

The U.S. stock market has rallied impressively since the March test of the SocGen low, racking up solid gains in April and May, but my bearish intermediate-term stock market outlook remains, due to multiple concerns:

  • inflationary pressures are mounting, consumer confidence is dropping;
  • credit turbulence remains a market mainstay;
  • the Federal Reserve faces the dual policy challenges of moderating economic growth and rising inflation; and
  • there is an increased likelihood of a squeeze in corporate profit margins (which will lead to disappointing profits).

Should the housing industry fail to recover (as I expect) and if the consumer is as weak as I anticipate, then the U.S. economy could be entering a period reminiscent of the late 1970s, which was a precursor to the inflationary conditions that existed in the early 1980s. A period of "blahflation" (blah economic growth coupled with nascent inflation) remains my base economic expectation. If my baseline expectation becomes reality, it will likely produce a contraction in P/E multiples and form the basis for an extended period -- perhaps as much as three to five years -- of substandard investment returns (at best) and a bear market (at worst).

Doug Kass is the author of The Edge, a blog on RealMoney Silver that features real-time shorting opportunities on the market.

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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