Kass: How a Year-End Rally Could Materialize

This blog post originally appeared on RealMoney Silver on Nov. 17 at 8:03 a.m. EST.

For nearly a decade, a surplus of cash has led to a shortage of common sense in the lending and borrowing of capital, and the markets are now in disarray as a financial hurricane has wreaked havoc upon the world's economies.

In a haze of uncertainty, market participants' visions of our economic future remain cloudy. That uncertainty and the loss of investor confidence and liquidity are manifested in historic intraday swings, suggesting that investors see a very wide range of possible economic outcomes.

A crisis 10 to 15 years in the making does not get fixed overnight.

There are going to be difficult days ahead, but, as I have noted, there are tentative signs of improvement. For example, the actions taken by the U.S. and other nations are beginning to have an impact. Though credit remains dear, credit markets are beginning to thaw. Businesses are slowly gaining access to essential short-term financing.

In other words, a measure of stability is returning to the financial system, even as equities around the world plummet.

Today, as investment icon Howard Marks recently stated, negativity reins supreme, possibly opening the door of opportunity for the contrarian.
I find that I often end with a quote from Warren Buffett, and often it's the same one:

    The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.

But now I want to talk about the flip side: When others conduct their affairs with excessive negativism, it's worth being positive. When others love 'em, we should hate 'em. But when others hate 'em, we can love 'em.

In "The Tide Goes Out" in March, I listed the stages of both bull and bear markets. I said that in the terminal third stage of a bull market, everyone is convinced things will get better forever. The folly of joining that consensus is obvious; people who invest thinking there'll never be anything to worry about are sure to get hurt.

In the third stage of a bear market, on the other hand, everyone agrees things can only get worse. The risk in that -- in terms of opportunity costs, or forgone profits -- is equally clear. There's no doubt in my mind that the bear market reached the third stage last week. That doesn't mean it can't decline further, or that a bull market's about to start. But it does mean the negatives are on the table, optimism is thoroughly lacking, and the greater long-term risk probably lies in not investing.

The excesses, mistakes and foolishness of the 2003-2007 upward leg of the cycle were the greatest I've ever witnessed. So has been the resulting panic. The damage that's been done to security prices may be enough to correct for those excesses -- or too much or too little. But certainly it's a good time to pick among the rubble.

-- Howard Marks, Chairman, Oaktree Capital Management (October 2008, " The Limits to Negativism")
The negativity is not surprising as economic growth is plummeting and unemployment is on the ascent. The brokerage community is in disrepair. Bear Stearns and Lehman Brothers have failed, and even Goldman Sachs ( GS) has been hobbled. Credit remains dear, and investment expectations have been ratcheted down. Individual and institutional investors are almost in a state of shock today as money has been withdrawn in record amounts from mutual funds and hedge funds. (The latter community will be a shadow of its former self by early 2009.)

In order to stage a substantive year-end recovery, Mr. Market needs some luck. President-elect Barack Obama needs to connect on a long bomb; he needs a Hail Mary. It is not an impossible task. What the market needs more than anything right now are some breathtakingly bold initiatives from engaged and bright leaders who address unconventional problems with unconventional remedies.

Stated simply, in order for the markets to rally into year-end, we need "shock and awe" policy and personnel decisions from the President-elect, and we need them to be announced as soon as is practically possible.

Over the weekend, Barron's cover story, " Dear Mr. President," made some recommendations aimed at "bolstering the confidence of consumers and businesses to get the economy back on its feet and restore order to financial markets."

Here is my take on some of the events and policy measures that might contribute to a sharp year-end rally.

Obama: Yes, He Can!

"Going for him, too, is a broad sense that the problems the President-elect faces are so deep, from war and peace to economic dislocation, that voters will be patient, give him time, and be grateful for any progress. Modest improvements will be seen as small triumphs."

-- Peggy Noonan, Wall Street Journal

A broad sense of anticipation and expectation greets the Obama Administration in January 2009, but it now must be earned. Americans want Obama to do well, as Americans want to prosper. The President-elect must be bold and timely as he now confronts a more difficult rival than Senator McCain -- the economy.

Recommend a massive tax stimulus. Senator Obama should be prepared to stand behind a massive fiscal stimulation package that represents as much as 4% of GDP, or at least $400 million, introduced in two stages. He should emphasize his intention to promote the package immediately following his inauguration.

Lower middle-class tax rates. Again, immediately!

Announce a $25 billion aid package to domestic automobile manufacturers. This might be distasteful to the President-elect, but it is necessary to the markets. (Note: Europe has already announced a $55 billion-plus automobile rescue package.)

Introduce large tax incentives for home ownership. On Friday, FDIC Chairwoman Sheila Bair unveiled the details for a plan to give government support to delinquent homeowners by artificially lowering rates and promising to share in the losses of borrowers who receive government help and still go into default. Obama should go further and announce a large ($10,000-plus) tax incentive for the purchase of new and existing homes in order to eradicate the glut of unsold homes.

Immediately announce Cabinet appointees with the broadest experience and the highest credibility, from both within the two political parties (a team of rivals) and from industry. More than ever today (and especially under the weight of debt and a contracting economy), a house divided against itself cannot stand. As soon as possible, Obama should announce his intention to embark on a magnanimous transpartisan approach to his appointments of 14 Secretaries of Departments and of the Attorney General in his Cabinet as well as the five other non-Secretary positions of Cabinet-level status. As well, he should announce appointments of specialists in some of these positions who are outside of the political realm. For example:

  • An experienced homebuilding executive such as Bob Toll, chairman of Toll Brothers (TOL) and a Democrat, could be asked to be Secretary of HUD.
  • Penny Pritzker, CEO of Classic Residence by Hyatt, could be asked to be Secretary of Commerce.
  • And Boone Pickens (Republican) could be asked to be Secretary of Energy.

Other appointments that would be greeted positively by the markets would be an inclusive list of some of the best and brightest -- that is, those with a sense of gravitas and with associated experience at the highest levels -- that could include former Senator Chuck Hagel (Republican, Nebraska) as Secretary of State, Caroline Kennedy as Secretary of Education, Lawrence Summers as Secretary of Treasury, Bob Gates could be asked to stay on as Secretary of Defense, Arizona Governor Janet Napolitano as Attorney General, Virginia Governor Tim Kaine as Secretary of Transportation, former Oregon Governor John Kitzhaber as Secretary of Interior, former New Jersey Governor Tom Kean as Secretary of Homeland Security, Jason Furman for Office of Management and Budget, etc. These sorts of bold bipartisan appointments would wow the markets as a sense of engagement is underscored.

But He Can't Do It Alone

So now that we've covered some steps that Obama could take to move the markets and the economy in a more positive direction, let us now turn our attention to a few things outside of the President-elect's control that need to occur in order to foster more optimism.

Cut interest rates. The Fed should slash the fed funds rate to zero.

One or two high-profile hedge funds must fail. Only after a high-profile or several high-profile hedge funds fail will markets "clear."

Reinstate the uptick rule in order to reduce the negative influence of the quant funds. There is little question that quant short selling (especially near the end of the day's trading sessions) is contributing to investors' pessimism and dismay. There is still even some question as to their role in taking down some financial institutions. Computer-generated strategies are clearly exacerbating down moves, as quant funds have begun to dominate trading and, given the contraction of other hedge fund asset classes (long/short, etc.), are benefiting from the reduced level of liquidity. Consider that the assets of the hedge fund industry peaked at about $1.8 trillion this spring. Let's say about $1.4 trillion remains and that about $300 billion will be redeemed by early next year; that leaves $1.1 trillion. Since quant funds manage about $200 billion in capital (and lever that two to four times), they probably represent an influential $600 billion-plus in assets. Authorities must reduce the downside (manipulative) influence of those quant funds by reinstating the uptick rule.


Know What You Own: Goldman Sachs operates in the diversified investments industry, and some of the other stocks in its field include Morgan Stanley ( MS), CME Group ( CME), NYSE Euronext ( NYX), Penn West Energy Trust ( PWE) and Nasdaq OMX Group ( NDAQ). For more on the value of knowing what you own, visit TheStreet.com's Investing A-to-Z section.


Doug Kass writes daily for RealMoney Silver , a premium bundle service from TheStreet.com. For a free trial to RealMoney Silver and exclusive access to Mr. Kass' daily trading diary, please click here.

At the time of publication, Kass and/or his funds had no positions in the 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.

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