This blog post originally appeared on RealMoney Silver on April 6 at 8:28 a.m. EDT.

The Little Engine That Could (also known as The Pony Engine) was a book written by Mary Jacobs in the early 1900s. It is a moralistic children's story about a stranded train who is unable to find an engine willing to take it over difficult terrain -- that is, until a little blue engine comes to its aid. And while repeating the mantra "I think I can ... I think I can," that little blue engine overcomes the seemingly impossible task of bringing the train to its destination.

The metaphor of The Little Engine That Could applies to life and to the current state of the stock market.

Early in the week of March 2, I appeared on CNBC's "The Kudlow Report," where I asserted that the U.S. stock market was within three days of bottoming for the year, and quite possibly for a generation. On Friday, March 6, following two days of further market weakness, I reaffirmed my prediction that the bottom was in.

A week later, on March 9, I reemphasized my generational low bottom call to a skeptical crew on CNBC's "Fast Money." On that show, I cited multiple valuation models I use to assess the current value of U.S. stocks, all of which made it clear to me that equities have incorporated a lot of bad news and were undervalued both absolutely and relative to fixed income:

  • The risk premium, the market's earnings yield less the risk-free rate of return, is substantially above the long-term average reading.
  • Using reasonably conservative assumptions (most importantly, a near 50% peak-to-trough earnings decline, which is over 3 times the drop in an average recession), the market has discounted 2009 S&P 500 earnings of about $47.
  • Valuations are low vis-à-vis a decelerating (and near-zero) rate of inflation. Indeed, the current market multiple is consistent with a 6% rate of inflation.
  • Stock prices as a percentage of replacement book value stand at 1 times, well below the 1.4 times long-term average.
  • The market capitalization of U.S. stocks vs. stated GDP has dropped dramatically, to about 80%, now at the long-term average. Warren Buffett was recently interviewed in Fortune Magazine and observed that this ratio was evidence that stocks have become attractive.
  • The 10-year rolling annualized return of the S&P is at its lowest level in nearly 75 years, having recently broken below the levels achieved in the late 1930s and mid 1970s.
  • A record percentage of companies have dividend yields that are greater than the yield on the 10-year U.S. note. At 46% of the companies, that is over 4 times higher than in 2002 and compares against only 5% on average over the past 30 years.

At the time, there were few who believed that stocks were bottoming and literally no one who thought that a sustainable market rally was even remotely possible. Chicken Little had regained credibility, and the Cassandra-like messages of Nouriel "Dr. Doom" Roubini (and those of his ilk) were universally accepted by the lemmings in the media and by the tortured hedge hogs who were then dramatically underinvested in equities and assured of their pessimistic views.

In early March, nearly everyone could explain why the market had declined and why it was unlikely to rebound, but hardly anyone could find a reason to rally. In marked contrast to the past, the general and business media seemed to refuse to consider factors that could contribute to a sustained advance in stock prices, especially given the nascent signs in retail, housing and production that the bottoming process had commenced.

It is equally important to recognize that only a handful anticipated the credit and economic travail of The Great Decession (something between a garden variety recession the The Great Depression), nevertheless, the alacrity and confidence in a continued dire outcome in the land of the Chicken Littles was something for me to behold one month ago. Three years ago, cash was not king, the buying power of private equity dominated the investment landscape, and no takeover (regardless of size) was impossible. Endowments, pension plans, banks and hedge funds jumped headlong into the leveraged world of private equity. Even two years ago, mutual and hedge funds were enthusiastically invested in equities (especially materials, commodities and energy stocks) as the newest paradigm of economic decoupling gained credence.

To summarize, in early March, cash (and liquidity) was back on the throne as king, and the great unwind of debt and the liquidation of overleveraged investments gained momentum as the hedge fund industry imploded further. The extreme negative sentiment that was associated with those conditions sowed the seeds for the bountiful harvest over the past four weeks.

With the benefit of hindsight, value was being put on our doorstep, and dinner was being served four weeks ago.

The first week of March marked the "Nouriel Roubini market bottom." The advice of those Johnny-come-lately Chicken Littles in early March proved horrific, and the performance of stocks over the past month has been the singular best four-week performance since 1933, as my watch list turned progressively more directionally upbeat.

Many have now boarded the love train.

Once again in March, as has happened in prior cycles' inflection points, markets have discounted the worsening rearview mirror and have peered optimistically into the future. Importantly, it is abundantly clear that we now have enough domestic economic data to point to a bottoming of production declines. This is particularly true as it relates to an imminent recovery/stabilization in housing, which is being catalyzed by a Fed-induced reduction in mortgage rates, record gains in affordability and a more favorable economic proposition of home ownership vs. renting.

Housing markets will bring us out just as they brought us in.

My month-old S&P forecast is materially on forecast. As a reminder, it was predicted on a parallel with the conditions that existed in the 1937-1939 U.S. stock market.

If the pattern of my prediction unfolds, the market will have only another 2% to 4% upside before a two-month price consolidation takes hold.

SPDR Trust (SPY) --Expectations
Bloomberg

If the above consolidation expectation is on target, I would emphasize the message I delivered in " The Death of Buy and Hold?" -- namely, gaming the markets will likely hold the key to delivering superior investment returns, especially over the next two to three months.

Short term, the market outlook will be importantly influenced by investor psychology and the degree to which public policy translates into economic traction.

In marked contrast to early March, when we were in a bull market for pessimism, today (as evidenced anecdotally by some breathless and relatively newly minted bullish commentary from previously bearish strategists, money managers, contributors on RealMoney, the "Fast Money" crew and elsewhere) many have recently come aboard the stock market's love train and have turned more constructive:

  • Sentiment surveys indicate a pickup in bullish sentiment.
  • The McClellan oscillator is way overbought.
  • RealMoney's Harry Schiller pointed out that the downtrend line for the S&P from the November 2008 and January 2009 highs shows resistance at 850.

Importantly, my early March variant view is no longer so.

The consequences of worshipping at the altar of price momentum can be punitive to the recently converted. One has to look no further than the recent downturn in gold shares and in the metal commodities, both of which became overowned and overbought asset classes.

Several other fundamental and technical factors could conspire to contribute to a period of market uncertainty and a healthy several months of backing and filling.

  • First-quarter earnings reports will be poor and guidance mixed to bad.
  • The success of the Federal Reserve programs, which seek to ring-fence toxic bank assets, will not be known for a few months.
  • A still levered and "tapped out" consumer could pause in its spending (after demonstrating sequential improvement in the first three months of 2009), even despite the benefits of lower interest rates and massive fiscal stimulation. This could jeopardize GDP growth forecasts, delay the domestic economy's recovery and result in even lower-than-expected corporate profits in 2009.
  • Capital raises (especially of a financial kind) may lie ahead. Already, the REIT industry has embarked upon an industrywide recapitalization.
  • Interest rates are starting to rise, providing some competition to stocks.
  • The always-present fear of an exogenous event.
  • Volatility remains elevated.

Weighing against the near-term consolidation argument is the historically significant improvement in the market's internals and breadth of the rally, with six 90% up days in four weeks, reflecting an abrupt change from the fear of being in to the fear of being out and left behind.

Regardless of whether a near-term consolidation is in the offing, volatility will remain heightened, and my formerly implausible S&P forecast now seems plausible.

Similar to The Little Engine That Could, the U.S. stock market appears positioned for further progress, and my mid- to late-summer destination of S&P 1,050 remains on target.

I think it can ... I think it can.

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's daily trading diary, please click here.


Know What You Own: The most active stocks in Monday's midday trading included Bank of America (BAC), Citigroup (C), SPDRs (SPY), Ford (F), Direxion Financial Bulls 3X Shares (FAS), Financial Select Sector SPDR (XLF) and PowerShares QQQ (QQQQ). For more on the value of knowing what you own, visit TheStreet.com's Investing A-to-Z section.

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 Long/Short LP.

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