Kass: Cautiously Opportunistic

This blog post originally appeared on RealMoney Silver on March 16 at 8:22 a.m. EDT.

Since mid-2010, I have incorrectly maintained a cautious market outlook.

As mentioned in my " Mea Culpa," my concerns have been consistently dismissed in the marketplace as equities have marched higher.

In support of my cautious investment view, I had offered a series of arguments on why numerous secular headwinds would produce nontraditional challenges to the notion of a smooth and self-sustaining economic recovery that was the foundation of the bullish cabal's baseline case.

Among my chief concerns have been:
  • an increase in structural unemployment;
  • rapidly advancing food and other input prices which raised the specter of lower corporate profit margins and disappointing (and more volatile) corporate profit growth;
  • fiscal imbalances (and the austerity that ensues) at the local and state levels;
  • an apparent unwillingness of either political party to address the federal budget deficit;
  • a still-moribund housing market plagued by a large shadow inventory of unsold homes;
  • a eurozone that has only temporarily deferred its sovereign debt problems;
  • rising instability in the Middle East and the resulting sharp increase in energy prices;
  • slowing growth in China; and
  • unknown tail risks of the previous economic and credit cycle.
As well, I have been concerned about the screwflation of and pressures on the middle class and the ultimate adverse impact on economic growth and corporate profitability.

I recently wrote, that , similar to Janus, the mythological Roman god depicted as having two heads facing opposite directions, the U.S. economy is two-headed.
  • One head is strong -- namely, the healthy and largest U.S. corporations.
  • The other head stares in the opposite the direction -- namely, the wobbly head of the U.S. consumer.
While corporations are flush with cash, running at a near-six-decade peak in operating margins and are within two quarters of eclipsing the previous peak in corporate profits, the economic crisis of 2007-2009 still haunts the average American.

According to the Bureau of Labor Statistics, 16% of the labor force, or over 25 million Americans, are out of work (14 million unemployed and 11 million underemployed). Mega trends of globalization, technological advances and the growing presence of temporary hirings as a permanent feature of the workplace form the basis of a secular rise in structural unemployment. Further depressing job creation is the fact that there are few growth engines to replace residential real estate, a sector that was such a prominent contributor to GDP and labor in the last cycle.

As I mentioned in a recent Alan Abelson Barron's column, every month brings more people who want jobs but who are leaving the workforce.

The plight of the middle class seems to be deteriorating further. The early-March jobs report disclosed that the average workweek declined by 0.1 hours, and there was no change in average hourly earnings. The employment participation, back down to 27-year lows, casts a long shadow on the domestic economy, which, despite normal population growth, currently employs only the same number of people as in 2003. Meanwhile, the cost of necessities (most notably of an energy kind) continues an uninterrupted rise, serving to obviously pressure not only the unemployed but the average Joe that has a job.

Most market bulls object to this (negative) analysis, citing a likely pickup in hiring that will be the natural consequence of an expanding domestic economy, rising profits and improving confidence in the future. They fully recognize the ultimate cost of policy and absence of budget constraint but view the due bills (of higher inflation and interest rates) as too far in the future to be concerned with, particularly given the confidence held regarding near-term profit growth.

By contrast, I have argued that the cracks in the bull case were growing more visible and that we were moving much closer to the bills of past policy coming due!

That said, the bulls have been right, and the bears, like myself, have been wrong.

As mentioned previously on The Edge (my RealMoney Silver trading diary), the market has ignored and rejected the shadows I have seen and instead has focused on the positives -- the most significant being growing confidence in a smooth and self-sustaining recovery buoyed by every ISM report and by a market-friendly Fed.

While I remain of the view that some portion of the recovery in the economy, in general, and in personal consumption expenditures, in specific, relates to "recession fatigue," I recognize that numerous sectors in the economy are still operating well below long-term trend lines. In all likelihood, this setup as well as the current economic momentum will support aggregate growth (above what we had forecast) in the months ahead -- even though the aforementioned nontraditional threats remain a cloud over intermediate-term growth.

An excellent example of potential pent-up demand is in the automobile market. February light-vehicle sales came in at a 13.4 million seasonally adjusted annual rate, compared to 12.6 million in January 2011. Excluding the August 2009 Cash for Clunkers sales of 14.2 million, February's sales figure was the best since August 2008. Domestic light-vehicle sales were reported at 10.35 million units compared to January's 9.59 million -- again the best monthly data, excluding Cash for Clunkers, in two and a half years.

From an historical perspective, automobile sales are still meaningfully below their trend line and have a lot of room to grow -- in the years that led up to the last recession in 2008, light-vehicle sales averaged close to 17 million units. For this reason and the chance that the U.S. automakers may take huge market share from the non-transplant portion of the Japanese companies, I am long Ford ( F) and General Motors ( GM).

This same observation applies to other industries, with well-below trend line residential real estate growth being the most conspicuous example of pent-up demand growth opportunity in the years ahead.

In Conclusion

When I weigh the positives and negatives, most investors and traders should continue to maintain a cautious stance until stocks drop further.

For now, err on the side of conservatism, as it is no time to be bold in either direction.

As discussed in my " 15 Surprises for 2011," I still expect a sideways market that ends the year relatively unchanged from year-end 2010. (So far so good, as of the close of trading yesterday, equities are flat for the year.)

Over the short term, signs of emerging technical deterioration -- the CBOE Volatility Index (VIX) has broken out of a downtrend in place since last summer -- fears of the impact of the Fed's exiting of QE2, continued sovereign debt problems, rising geopolitical worries, a dysfunctional U.S. government that kicks the can of budgetary problems down the road and new tech concerns (excess inventories in optical and tablet markets) were already pointing to some potential market vulnerability.

This week, the uncertainty regarding the Japanese nuclear disaster has put a further crimp into the short-term market outlook. We know that the technology supply chain has been impacted by the Japanese earthquake, as Citigroup hosted a conference call this morning to discuss such issues at Apple ( AAPL).

While I have tried to articulate the likely worldwide and U.S. economic adjustment that will no doubt follow this tragedy -- it is extremely hard for anyone to forecast with much precision the impact that this exogenous event will have on confidence (consumer and business). I can say with a fair degree of certainty that confidence will drop, serving ultimately to weigh on and reduce consensus economic growth forecasts ahead.

Japan's nuclear crisis impact on the U.S. stock market is even more difficult to predict with any degree of accuracy, though on The Edge, I have offered the analysis that if it is contained, most of the effect may have already been discounted in the recent 40-handle drop in the S&P 500.

Barring a catastrophe in Japan, I feel comfortable in writing that any further stock market decline could provide a reasonably attractive entry point on the long side, as better risk/reward opportunities will evolve.

Regardless of market direction, I plan to more aggressively complement my longer-term investment ideas discussed in The Edge by actively writing about and taking advantage of shorter-term catalyst-driven trading opportunities that seem likely to multiply in the more volatile environment I expect to be with us for some time to come.

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 were long F and GM, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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