Kass: The Case for a Summer Snooze Fest

This blog post originally appeared on RealMoney Silver on July 9 at 8:05 a.m. EDT.

Since I have been out for a few days of meaningful and persistent downside pressure, let's frame the market expectations that have led up to my current outlook for stocks over the balance of the summer and into the fall.

Like Shakespeare's Polonius, I adopted a neutral view of U.S. equities in late May in a column entitled " Neither a Bull nor a Bear Be."

As stocks continued to rise, I argued in early June on CNBC's "The Kudlow Report" that, while I remained confident that a generational low would not likely be breached for years (if not forever), equity valuations had nonetheless more than discounted the second derivative improvement in the economy, and stocks were running ahead of the real economy.

In addition, I further opined a month ago:

  • More tangible signs of economic traction are necessary before the markets move higher.
  • The trajectory of economic growth will be shallow and will likely disappoint the equity markets during the second half of 2009.
  • Massive cost cutting has resulted in better-than-expected first-quarter 2009 profits, but it holds a downside as significant employee layoffs (and a still-weakened consumer) threaten the seeds of domestic economic growth over the intermediate term.
  • Savings rates will remain high, and personal consumption expenditures will remain low for an extended period of time.
  • The specter of rising taxes and higher interest rates in late 2009/early 2010 will likely impact an already fragile recovery in the economy and in the markets -- a double-dip is due then.
  • Near term the market looked increasingly exposed and the upside was certainly capped.

In mid June, as stocks moved to 2009 highs, I stressed that the markets were getting stretched ever more by investors and traders who worshiped at the altar of price momentum. I further suggested that, while the economy was getting "less worse," stocks were increasingly vulnerable and ahead of the real economy.

I went on record that a decline of between 5% and 10% was imminent.

As stocks began to slip during the following week, in " Three Summer Scenarios" I offered the view that, following the selloff, a sideways correction or a deep correction held a combined probability of 65% and that a continued rally held only about a 35% chance.

Thus far, the market action in July has been abysmal and has generally confirmed my forecasts. At Wednesday's mid-afternoon low, the S&P 500 had fallen by about 8.5% from it's yearly high, at the upper end of my mid-June forecast of a drop of between 5% and 10%.

Just as I wrote that it was wrong to buy following the strength of three weeks ago, I believe it to be wrong to sell the recent weakness as I see emerging value developing in a growing set of stocks. Most technicians, following the recent drop, have turned more bearish, and I suspect that the sentiment surveys and short interest will follow the technicians. As well, we are quickly moving into oversold territory. All of these factors can be interpreted as contrarian and as more positive signals.

However, as I mentioned to Sir Larry Kudlow a month ago, just as there is limited causality between advancing stock prices and an improving economy, a declining stock market does not necessarily suggest an immediate deterioration or disappointment in economic activity.

Indeed, despite the disappointing jobs report last week, which appears to be the proximate cause for July's market drubbing, I see light at the end of the economic tunnel.

I still see a production boom caused by the replenishment of inventories (from a very low base).

I still see stabilization in residential real estate as affordability records multi-decade highs and as the relationship between home ownership grows substantially more compelling than renting.

I still see the domestic economy in (but shortly moving out of) the final phase of deteriorating unemployment reports as the massive fiscal and monetary stimulation plans begin to take hold in the last half of 2009.

And, as reflected in my previous writings (see below), I still believe the odds favor my scenario of a sideways correction following the recent overbought drop, which lays the groundwork for another tradeable (but final) leg higher.

Looking beyond the near term, I would emphasize that I view the two correction scenarios as bolstering the market outlook during the fall-winter period. Both scenarios would serve to build up skepticism, shake up complacency and make it difficult for many investors to have the nerve to get back in.... A subsequent rally out of these two scenarios would be fueled by investors chasing strength as even in bear market rallies (1938-1939), there is typically more than one leg higher. By contrast, a continued rally would expose the markets to a more serious correction.
-- Doug Kass, " Three Summer Scenarios" (June 22, 2009)

Stated simply, I see the current correction as a normal reaction to a seismic rally from the unprecedented and compressed levels of early March.

My Updated and Current Market View

Consistent with my expectations of a sideways correction, the world's stock markets appear to be poised to go to sleep for the balance of the summer.

Over the course of the next two months, I expect the S&P 500 to trade in a relatively narrow range of between 850 and 925.

Here's why I find that there are few catalysts that would move the market in any meaningful direction from current levels:

  • Second-quarter earnings will produce little in the way of surprises. While being nothing to write home about, corporate profits should continue the trend of the previous quarter, exhibiting tepid top-line sales growth, but profits will be buoyed by drastic cost cutting.
  • Market participation should be especially light. Not only is it summertime, but the wounds of 2007-2008 must be allowed to heal. Long weekends (taking off Fridays) will likely grow longer (as many will also take off Thursdays or Mondays).
  • Macroeconomic statistics should continue to stabilize, but the progress should not meaningfully deviate from consensus expectations. Housing will be aided by lower pricing, a continued improvement in affordability and in a reduction in the cost of home ownership relative to renting. The replenishment of manufacturing inventories will stoke modest third-quarter GDP growth but will be muted by a large output gap. Employment statistics will get "less worse," but, again, the recovery will be modest in scope and settling of the double-dip debate will linger. All in all, the principal signs of economic activity that I expect to be reported in July through September will not be enough to produce an upside surprise but neither will it be too little to generate meaningful downside momentum in equities.
  • With little in the way of substantive change in economic growth expectations, commodities, too, should be on snooze mode.
  • Political initiatives should be modest in July and August as our leaders take leave of Washington, D.C., and also vacation.
  • I expect little in the way of hedge fund or mutual fund flows (inflows or outflows) to generate a material change in the supply and demand for stocks, and with fixed-income prices (and yields) exhibiting limited fluctuation, the reallocation of pension plans into stocks and out of bonds will likely ebb in the months ahead.
  • With valuation arguably at an historical mid range, P/E multiples seem to be reasonably fair and not subject to a major move in either direction.
  • It's hard to see a meaningful swing in sentiment under the aforementioned muddle-along economic setting that contains few surprises.

In summary, last weekend's Independence Day celebration might have already marked the end of the market's summer fireworks and of the market's decline, as the corporate profit and economic pictures (along with other factors) will likely remain cloudy, inconclusive and absent any surprises. Also contributing to the possible snooze fest are reasonable valuations (against normalized profits), midrange sentiment conditions and the absence of meaningful fund inflows or outflows. (If my forecast of a market chill and slumber are met as an 850-to-925 base is built in the S&P 500, selling option premium might be the most productive investment strategy during the summer of 2009).

The next important move will require some modest patience as summer is over in only two months or so. Fortunately, the fall holds promise for the stock market.

My baseline expectation is that the expected summer snooze fest could be followed by a meaningful, maybe even an explosive and certainly playable up leg that, from my perch, should be sold into in anticipation of the first half of 2010's double-dip and within the context of an extended period (in years, not months) of inconsistent and lumpy growth that will be difficult for both corporate managers and investment managers to navigate as the nontraditional headwinds gain strength and impact.

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: Some of the most active stocks in Thursday's midday trading include Bank of America (BAC), SPDRs (SPY), Financial Select Sector SPDR (XLF), Alcoa (AA), Citigroup (C), PowerShares QQQ (QQQQ) and General Electric (GE).

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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