This commentary originally appeared at 7:00 a.m. EST on Dec. 27 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.
"Never make predictions, especially about the future." -- Casey StengelWhile I had a reasonably successful surprise list for 2011, with about half my surprises coming to fruition, the real story was that I achieved something that is almost impossible to accomplish. My most important surprise (No. 4) was that the S&P 500 would end the year at exactly the same price that it started the year (1257) and that the range over the course of the year would be narrow (between 1150 and 1300). As explained below, both predictions were remarkably close to what actually occurred.
My Biggest Surprise for 2011 Was Eerily PrescientAs we entered 2011, most strategists expressed a sanguine economic view of a self-sustaining domestic recovery and shared the view that the S&P 500 would rise by about 17% and would end the year between 1450 and 1500 vs. a year-end 2010 close of 1257. >>Bonus: 5 More Surprises for 2012 By contrast, I called for a sideways market, stating that the S&P would be exactly flat year over year. To date, that surprise has almost come true to the exact S&P point. Remarkably, at around midday last Friday, Dec. 23, the S&P 500 was trading at 1257 -- Friday's closing price was 1265 -- precisely the ending price on Dec. 31, 2010! (There are still four trading days left in the year, so technically the exercise is not yet over.) A flat year is a much rarer occurrence than many would think. According to The Chart Store's Ron Griess, in the 82 years since 1928, when S&P data was first accumulated, the index was unchanged in only one year (1947). And in only three of the 82 years was the annual change in the S&P Index under 1% -- 1947 (0.00%), 1948 (-0.65%) and 1970 (+0.10%).
Dueling Annual Surprise Lists: Kass vs. WienBy means of background and for those new to Real Money Pro, nine years ago, I set out and prepared a list of possible surprises for the coming year, taking a page out of the estimable Byron Wien's playbook, who originally delivered his list while chief investment strategist at Morgan Stanley ( MS) then Pequot Capital Management and now at Blackstone ( BX). Every year I, and many others, look forward to Byron "Brontosaurus Rex" Wien's annual compilation (hat tip to "Squawk Box's" Joe Kernen for giving him the moniker). Byron has had a remarkable (and almost uncanny) record of his surprises becoming realities ever since he started his exercise back in 1986. His picks in 2009 were particularly accurate, but his surprises for 2010 were considered by some to be off the mark. Here is Byron Wien's surprise list for 2011. The tone of almost all of Byron's 2011 surprises was diametrically opposed to my list -- namely, his list was rooted in optimism, while my list was rooted in pessimism. Where I saw slowing and sluggish economic growth, a weak housing market, a European recession by year-end and a lackluster stock market, Byron saw improving prospects. His principal surprises for the economy, interest rates, housing, the eurozone's debt crisis and the housing markets were off the mark in 2011. (Byron is an honest guy, so he would be the first to admit this.) Specifically, Bryon expected U.S. real GDP growth of close to 5% (real U.S. GDP over the past 12 months saw only a 1.8% growth rate), a 5% yield on the 10-year U.S. note (which now stands at 2.03%, but, hey, I got that one wrong, too!), a year-end S&P 500 close near 1500 (now at 1265), a sharp recovery in housing starts to 600,000 and a rise in the Case-Shiller Home Price Index, and a quiescent and non-market-disruptive European debt situation. He was very correct on the price of gold (where I was far off base) and on benign inflationary pressures.
Lessons Learned Over the Years
"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown." -- Woody AllenThere are five core lessons I have learned over the course of my investing career that form the foundation of my annual surprise lists:
- how wrong conventional wisdom can consistently be;
- that uncertainty will persist;
- to expect the unexpected;
- that the occurrence of Black Swan events are growing in frequency; and
- with rapidly changing conditions, investors can't change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.
Consensus Is Often Wrong
"Let's face it: Bottom-up consensus earnings forecasts have a miserable track record. The traditional bias is well known. And even when analysts, as a group, rein in their enthusiasm, they are typically the last ones to anticipate swings in margins." -- "UBS's Top 10 Surprises for 2012" (hat tip to Zero Hedge)Let's get back to what I mean to accomplish in creating my annual surprise list. It is important to note that my surprises are not intended to be predictions but rather events that have a reasonable chance of occurring despite being at odds with the consensus. I call these "possible improbable" events. In sports, betting my surprises would be called an "overlay," a term commonly used when the odds on a proposition are in favor of the bettor rather than the house. The real purpose of this endeavor is a practical one -- that is, to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs on small wagers/investments. Since the mid-1990s , the quality of Wall Street research has deteriorated in quantity and quality (due to competition for human capital at hedge funds, brokerage industry consolidation and former New York Attorney General Eliot Spitzer-initiated reforms) and remains, more than ever, maintenance-oriented, conventional and groupthink (or groupstink, as I prefer to call it). Mainstream and consensus expectations are just that, and in most cases, they are deeply embedded into today's stock prices. It has been said that if life were predictable, it would cease to be life, so if I succeed in making you think (and possibly position) for outlier events, then my endeavor has been worthwhile. Nothing is more obstinate than a fashionable consensus, and my annual exercise recognizes that over the course of time, conventional wisdom is often wrong. As a society (and as investors), we are consistently bamboozled by appearance and consensus. Too often, we are played as suckers, as we just accept the trend, momentum and/or the superficial as certain truth without a shred of criticism. Just look at those who bought into the success of Enron, Saddam Hussein's weapons of mass destruction, the heroic home-run production of steroid-laced Major League Baseball players Barry Bonds and Mark McGwire, the financial supermarket concept at what was once the largest money center bank Citigroup ( C), the uninterrupted profit growth at Fannie Mae ( FNM) and Freddie Mac ( FRE), housing's new paradigm (in the mid-2000s) of noncyclical growth and ever-rising home prices, the uncompromising principles of former New York Governor Eliot Spitzer, the morality of other politicians (e.g., John Edwards, John Ensign and Larry Craig), the consistency of Bernie Madoff's investment returns (and those of other hucksters) and the clean-cut image of Tiger Woods.
"Consensus is what many people say in chorus but do not believe as individuals." -- Abba Eban (Israeli foreign minister from 1966 to 1974)In an excellent essay published a year ago, GMO's James Montier made note of the consistent weakness embodied in consensus forecasts. As he puts it, "economists can't forecast for toffee." Attempting to invest on the back of economic forecasts is an exercise in extreme folly, even in normal times. Economists are probably the one group who make astrologers look like professionals when it comes to telling the future. Even a cursory glance at Montier's Exhibit No. 4 (above) reveals that economists are simply useless when it comes to forecasting:
They have missed every recession in the last four decades. And it isn't just growth that economists can't forecast; it's also inflation, bond yields, unemployment, stock market price targets and pretty much everything else.... If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared! -- James Montier
How Did Consensus Do in 2011?As we entered 2011, consensus estimates for economic growth, corporate profits, stock price targets and interest rates were generally optimistic and, as is typical, grouped in an extraordinarily tight range. Last year, I chose to use Goldman Sachs' ( GS) forecasts as a proxy for the consensus. Here were Goldman's forecasts for 2011, with the likely or actual 2011 full-year returns/results in parentheses:
- 2011 U.S. real GDP up 3.4% (up 1.8% actual), and global GDP up 4.7% (up 3.8% actual);
- 2011 S&P 500 operating profits of $94 a share ($97 a share actual);
- year-end S&P 500 price target at 1450 (Friday, Dec. 23's close: 1265 actual);
- 2011 inflation (core CPI) of +0.5% (+1.7% actual); and
- 2011 closing yield on the U.S.10-year Treasury note at 3.75% (2.03% actual).
How Did My Surprise List for 2011 Fare?
"Those who cannot remember the past are condemned to repeat it." -- George SantayanaMy surprises for 2011 attacked some of the closely grouped and nearly universally optimistic consensus expectations on the part of money managers, strategists, economists and members of the fourth estate. My intention was not to be a Cassandra or to be a contrarian for contrary's sake but rather to recognize that most prefer the dreams of the future to the history of the past. My surprises embodied an often repeated lesson of history: What seems easy for (bullish) investors to imagine today might prove more difficult to deliver, as prospect is often better than possession. Looking at history, there was no better example of misplaced optimism than in the period leading up to the Great Decession of 2008-2009, providing a vivid reminder of the poor forecasting ability and investment risks associated with the crowd's baseline expectations and the value of a surprise list that deviates from that consensus. Three years ago, only the remnants anticipated anything near the magnitude of the fall in the world's economies and capital markets, despite what appeared to be clear and accumulating evidence of economic uncertainty and growing credit risks (and abuses). The analysis of multi-decade charts and economic series convinced most (along with other conclusions) that home prices were incapable of ever dropping, that derivatives and no-/low-document mortgage loans were safe, that there was no level of leverage (institutional and individual) too high and that rating agencies were responsible in their analysis. Importantly, they also failed to see the signposts of an imminent deterioration in business and consumer confidence that was to result in the deepest economic and credit crisis since the early 1930s.
In the famous simile of the cave, Plato compares men to prisoners in a cave who are bound and can look in only one direction. They have a fire behind them and see on a wall the shadows of themselves and of objects behind them. Since they see nothing but the shadows, they regard those shadows as real and are not aware of the objects. Finally one of the prisoners escapes and comes from the cave into the light of the sun. For the first time, he sees real things and realizes that he had been deceived hitherto by the shadows. For the first time, he knows the truth and thinks only with sorrow of his long life in the darkness. -- Werner Heisenberg, Physics and Philosophy: The Revolution in Modern ScienceLast year's surprise list achieved about a 50% success ratio. Forty percent of my 2010 surprises were achieved, while I had a 50% success rate in 2009, 60% in 2008, 50% in 2007, one-third in 2006, 20% in 2005, 45% in 2004 and one-third came to pass in the first year of my surprises in 2003. My surprise list for 2011 hit on some of the important themes that dominated the investment and economic landscape this year. Below is a list of some of my accurate surprises from last year's list.
- Markets: As discussed previously, the market was practically unchanged in 2011, and the year's range almost perfectly coincided with my No. 4 surprise. Also, group performance surprises were fulfilled -- for instance, "During the second half of the year, housing stocks crater, and the financial sector's shares erase the (sector-leading) gains made in late 2010 and early 2011." I also was correct in expecting asset managers' shares to fall lower and underperform.
- The U.S. economy: Real GDP in the U.S., as I expected, was disappointing at about half consensus growth expectations. Screwflation of the middle class was a dominant theme, and I incorporated screwflation in my surprise list and in a Barron's "Other Voices" editorial in June. Americans, I thought, would remain in a foul mood, as the jobs and housing markets failed to improve to the degree expected by most. My surprise of social unrest was also realized around the world -- over there in the Arab Spring and over here in the Occupy Wall Street movement.
- The European economy: Over there and as I suggested a year ago, "multiple country austerity programs moved Europe back into recession by year-end 2011."
- China's economy: I wrote that "China continues to tighten, but inflation remains persistent, economic growth disappoints and its stock market weakens further." All happened.
- U.S. politics: I wrote "increased hostilities between the Republicans and Democrats become a challenge to the market and to the economic recovery next year. As the 2012 election moves closer, President Obama reverses his seemingly newly minted centrist views.... The resulting bickering yields little progress on deficit reduction. Nor does the rancor allow for an advancement of much-needed and focused legislation geared toward reversing the continued weak jobs market." Trust in our leaders was indeed lost throughout 2011 -- approval ratings hit an all-time low during 2011 for Congress) and for the president -- and political gridlock and inertia adversely impacted sentiment as confidence figures plummeted by late summer.
- Republican presidential candidate: Mitt Romney, as expected, is the Republican Party's presidential frontrunner (but Ryan and Thune never were in the fray).
- Commodity prices: Throughout the year, "the rise in the price of commodities was one of the primary market themes and concerns."
- Gold: I was correct in expecting volatility in the price of gold but very wrong in the direction of the price of gold when I wrote, "The price of gold plummets by more than $250 an ounce in a four-week period in 2011 and is among the worst asset classes of the new year. The commodity experiences wild volatility in price (on five to 10 occasions, the price has a daily price change of at least $75), briefly trading under $1,050 an ounce during the year and ending the year between $1,100 and $1,200 an ounce."
- Takeovers: Though Microsoft (MSFT) has not yet made a bid, my Yahoo! (YHOO) deal surprise turned out to be materially correct. "Among the most notable takeover deals in 2011, Microsoft launches a tender offer for Yahoo!.... The private equity community joins the fray."
- Internet as the tactical nuke of the digital age: "Cybercrime likely explodes exponentially as the Web is invaded by hackers." Dead on, as serious hacking incidents are occurring with increased frequency.
- Expanding insider trading charges: It was a record year of insider trading indictments and convictions, from Raj to many other ne'er-do-wells (including research network consultants, hedge funds, corporations and even a member of the board of directors of Goldman Sachs). "The SEC's insider trading case expands dramatically, reaching much further into the canyons of some of the largest hedge funds and mutual funds and to several West Coast-based technology companies." (Some of us even learned this year for the first time that Congress is legally permitted to be in the insider trading game!)
- Though the price of gold was volatile (and did sustain quick $200-per-ounce drops), it did not fall and was among the best asset classes in 2011.
- There was no military confrontation between China and India over water rights.
- The price of oil didn't soar to over $125 a barrel.
- The yield on the 10-year U.S. note did not spike to 4.25%.
- Food and restaurant stocks were not among the worst-performing market sectors.
- Hillary Clinton and Joe Biden did not switch jobs, though Clinton is resigning her post as Secretary of State.
- While Speaker of the House John Boehner's tenure has been uneven, he was not replaced by Paul Ryan.
- A third political party did not appear (though it is never too late!).
- There was no peaceful regime change in Iran.
What Is Consensus for 2012?As we enter 2012, investors, strategists and talking heads are again grouped in a narrow consensus, but, in contrast with last year's almost universally bullish views on the economy and on the U.S. stock market, the consensus is far more downbeat, reflecting near universal acceptance of Pimco's Bill Gross's " new normal" of de-leveraging, de-globalization and re-regulation. Again, let's use Goldman Sachs' principal views of expected economic growth, corporate profits, inflation, interest rates and stock market performance as a proxy for consensus. Below are Goldman Sachs' forecasts for 2012:
- 2012 U.S. real GDP up 1.8%, and global GDP up 3.2%;
- 2012 S&P 500 operating profits of $100 a share;
- year-end 2012 S&P 500 price target at 1250;
- 2012 inflation of +1.7%; and
- 2012 closing yield on the U.S.10-year Treasury note at 2.50%.
My 15 Surprises for 2012
"More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other to total extinction. Let us pray we have the wisdom to choose correctly." -- Woody AllenEver since 2007, my contrarian and variant surprise lists were almost always downbeat relative to consensus. I adopted a Kafkaesque sense of hopelessness and an almost Woody Allen-like sense of foreboding (see quote above). It was as if I was giving a traffic report from the perspective of chronicling the automobile accidents on I-95.
You'll be swell! You'll be great!But, my new surprises for 2012 represent a fundamental turn toward optimism and a marked departure from the pessimism expressed in my recent surprise list history -- as I move metaphorically from the Broadway stage of Woody Allen's 1966 play Don't Drink the Water to Stephen Sondheim and Jule Styne's 1959 Broadway musical Gypsy's " Everything's Coming Up Roses" (see lyrics above). For the last few years, since the financial and economic crisis of 2008-2009, caution, restraint and the word "no" have characterized and dominated the economic, social and political backdrop. In 2012, however, our surprise list moves toward an inflection point in which bolder steps, expansiveness and the word "yes" begin to dominate the political, economic and stock market stages. This new, brighter and more positive narrative is the essence and the common thread contained in my surprise list for 2012. (And this year, following each surprise, I am introducing a specific strategy that might be employed in order for an investor to profit from the occurrence of these possible improbables). Surprise No. 1: The U.S. stock market approaches its all-time high in 2012. The beginning of the New Year brings a stable and range-bound market. A confluence of events, however (discussed further in the body of the 15 Surprises for 2012), allows for the S&P 500 to eclipse the 2000 high of 1527.46 during the second half of the year. The rally occurs as a powerful reallocation trade out of bonds and into stocks provides the fuel for the upside breakout. The market rip occurs in a relatively narrow time frame as the S&P 500 records two consecutive months of double-digit returns in summer/early-fall 2012. Strategy: Buy out-of-the-money SPDR S&P 500 ETF Trust (SPY) calls. Surprise No. 2: The growth in the U.S. economy accelerates as the year progresses. The U.S. economy muddles through in early 2012, but, with business, investor and consumer confidence surging in the fall, real GDP accelerates to over 3% in the second half. Unemployment falls slightly more than consensus, but the slack in the labor market continues to constrain wage growth. Domestic automobile industry sales soar well above expectations, benefiting from pent-up demand and an aging U.S. fleet. Inflation is contained but begins to be worrisome (and serves as a market headwind) in late 2012. Corporations' top-line growth is better than expected, and wage increases are contained. Operating margins rise modestly as sales growth lifts productivity and capacity utilization rates. Operating leverage surprises to the upside as 2012 S&P profits exceed $105 a share. A noteworthy surprise is that the residential real estate market shows surprising strength. The U.S. housing market becomes much bifurcated (in a market of regional haves and have-nots), as areas of the country not impacted adversely by the large shadow inventory of unsold homes enjoy a strong recovery in activity and in pricing. The Washington, D.C., to Boston, Mass., corridor experiences the most vibrant regional growth, while Phoenix, Las Vegas and areas of California remain weak. The New York City market begins to develop a bubbly speculative tone. Florida is the only area of the country that has had large supply imbalances since 2007 that experiences a meaningful recovery, which is led by an unusually strong Miami market. Strategy: Buy Home Depot (HD), Lowe's (LOW), building materials and homebuilders, and buy auto stocks such as Ford (F) and General Motors (GM).
Gonna have the whole world on the plate!
Clear the decks! Clear the tracks!
You've got nothing to do but relax.
Blow a kiss. Take a bow.
Honey, everything's coming up roses! -- Stephen Sondheim and Jule Styne, " Everything's Coming Up Roses"
- A broad infrastructure program focused on a massive build-out and improvement of the U.S. infrastructure base -- the restoration of our country's highways, bridges and buildings and an extensive internet bandwidth expansion are embarked upon.
- The annual increase in government spending is limited to the change in the CPI.
- A comprehensive jobs plan includes new training programs -- all veterans are made eligible to tuition subsidies to vocational schools and colleges.
- A Marshall Plan for housing is introduced, highlighted by a nationwide refinancing proposal adopted for all mortgagees (regardless of loan-to-values).
- A series of new tax increases, including a plan to raise taxes on the families with an income in excess of $500,000 a year (a two-year income tax surcharge of 5%-10%) and some other more imaginative, outside-the-box proposals (e.g., a tax on sugar products) are introduced.
- Mean test entitlements, freeze entitlement payouts and gradually increase the Social Security retirement age to 70 years old.
- A comprehensive plan is designed to rapidly develop all our energy resources.
Another tough yearStrategy: Buy JPMorgan Chase (JPM), Citigroup and the Financial Select Sector SPDR (XLF).
To cover this group
Down 40 to 50
And they're still in the soupRegulation, litigation
And potential mitigation
Time to put it all aside
And enjoy your vacation....But if Republicans win the White House
It's them I'd like to thank
Cause they'll not only change the top seat
But also the bill of Mr. Dodd and Mr. FrankSo Happy New Year
Hope you found this rap a little clever
And buy some big banks and brokers next year
Don't hide in the regionals forever! -- "Nomura Securities' Year-End Rap"