Kass: A Summary of My Bearishness

This blog post originally appeared on RealMoney Silver on Aug. 10 at 7:40 a.m. EDT.

Let me summarize my market thoughts, as expressed on RealMoney Silver over the past two weeks.

As I see it, the bull market argument is that the U.S. is exiting the recession just like the many that preceded the current one. Consequently, corporate profits will exceed consensus forecasts in tandem with:
  • the resumption of revenue growth;
  • the record fiscal and monetary stimulation;
  • an export-led Asian recovery; and
  • the operating leverage associated with productivity gains achieved through draconian cost cuts and influenced by the benefits of wage deflation.
The bulls further argue in favor of Say's Law of Production (i.e., business drives consumer incomes and spending) and that the high-tax health and energy bills introduced by the President have been recently set back (as the Blue Dog Democrats and the liberal leadership are already battling).

The bear market argument that I have now embraced is that we are seeing nothing more than a second derivative recovery and that, owing to a temporary replenishment of inventories, the economy is only getting less worse (or getting better from a depressed level). The ingredients for a durable and self-sustaining recovery are missing as an economic double-dip grows more likely in a climate of corporate cost cuts, elevated jobless rates, wage deflation and continued pressure on personal consumption expenditures. Bears, such as myself, reject Say's Law of Production and view weakening consumer incomes and spending as a poor foundation and as inadequate drivers to improving business activity into 2010.

The economic downturn of 2007-2009 has already been different this time in scope and duration. For example, unlike the other post-depressions/recessions of the last century, we have already witnessed two consecutive quarterly drops in nominal GDP. As well, the 20-month-old recession has resulted in a near 4% drop in real GDP vs. drops of between 2.5% and 3.0% in the mid 1970s and early 1980s recessions. The U.S. economy came out quickly from those prior downturns, with recoveries to new peaks in economic activity taking only three or four quarters.

My view is that it will continue to be different this time as the typical self-sustaining economic recovery of the past will not be repeated for 10 important reasons.
  1. Cost cuts are a corporate lifeline and so is fiscal stimulus, but both have a defined and limited life.
  2. Cost cuts (exacerbated by wage deflation) pose an enduring threat to the consumer, which is still the most significant contributor to domestic growth.
  3. The consumer entered the current downcycle exposed and levered to the hilt, and net worths have been damaged and will need to be repaired through higher savings and lower consumption.
  4. The credit aftershock will continue to haunt the economy.
  5. The effect of the Fed's monetarist experiment and its impact on investing and spending still remain uncertain.
  6. While the housing market has stabilized, its recovery will be muted, and there are few growth drivers to replace the important role taken by the real estate markets in the prior upturn.
  7. Commercial real estate has only begun to enter a cyclical downturn.
  8. While the public works component of public policy is a stimulant, the impact might be more muted than is generally recognized. There may be less than meets the eye as most of the current fiscal policy initiatives represent transfer payments that have a negative multiplier and create work disincentives.
  9. Municipalities have historically provided economic stability -- no more.
  10. Federal, state and local taxes will be rising as the deficit must eventually be funded, and high-tax health and energy bills also loom.
"The balance of financial terror ... is a situation where we in the U.S. rely on the cost to others of not financing our current account deficit as assurance that financing will continue."

-- Lawrence Summers
Among the non-traditional headwinds listed above, a burgeoning fiscal deficit and the financial instability of our state and local municipalities are among two of the most significant challenges that face consumers, corporations and investors. Though the bulls generally agree with the presence of these intermediate-term challenges (especially the spiraling deficit and a nervous U.S. dollar stalemate), they generally dismiss them both over the short term, favoring the belief that the current upside surprises in earnings will dominate the market landscape in influence. I would argue that the aforementioned challenges are ever more predictable in consequence and will serve as a governor to further gains in market valuations.

An avalanche of spending by the public sector is now following an avalanche of spending by the private sector. In essence, we are (perhaps necessarily) fighting the slowdown with the same sort of incendiary kerosene that put us into the mess.

Profligate spending comes at a cost, a cost that we will experience sooner than later. It is only a matter of time before policy makers address the financing of this accumulated debt and the great reflation experiment of 2009 by raising taxes significantly. We have already witnessed the start of what is likely to become an avalanche of changing tax policy. New York City imposed its first sales tax increase in 35 years (rising from 8.375% to 8.875%), and, on the same day, the state of New Jersey imposed an additional tax hike on wholesale liquor distributors' sales of liquor and wine, which is sure to be passed on to the consumer. In Oakland, Calif., even the "high life" is being taxed as the city has recently passed a tax on marijuana sales and the state of California appears to be close in following Oakland's example.

This is just the start of a nascent and broad trend toward much higher taxes, a growth-impeding and P/E-diminishing secular development.

The market optimism that we are now experiencing in the expectation of a clean handoff of the baton of stimulation from the consumer (2000-2006) to the government (2008-????) might be more short-lived than many believe, as the price of stimulation, regardless of whether it's source is the private or public sector, holds the promise of being more of a growth-retardant. With the debt super-cycle continuing apace (but in a public sector context), the fragility and inherently unstable "balance of financial terror" argues for a not-so-benign and extremely volatile stock market future.

Unquestionably, the animal spirits have been in full force as shorts are scrambling to cover and many more are joining the ever more vocal and growing bullish chorus. But to me, the margin of safety is becoming ever more thin as the enemy of the rational buyer -- namely, optimism -- reaches new heights.

In summary, since a self-sustaining economic recovery appears doubtful, I do not believe that we have started a new bull market. Rather, it is more than likely that economic growth will disappoint in late 2009/early 2010 as the domestic economy confronts many of the emerging secular challenges discussed above.

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.

At the time of publication, Kass and/or his funds had no positions in the stocks mentioned, although holdings can change at any time.


Know what you own: Some of Monday's most active stocks at midday include Citigroup (C), Bank of America (BAC), Ford (F), SPDRs (SPY), CIT Group (CIT), Financial Select Sector SPDR (XLF) and General Electric (GE).

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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