Two Important Questions

This column originally appeared on Real Money Pro at 9:39 a.m. EDT on May 21.

NEW YORK ( Real Money) -- After traveling for most of last week, I wanted to address the two most important questions facing investors and traders:

  1. Why has the market plummeted?
  2. What is the market's outlook?

Neither question is easy to answer, but I will try my best.

By means of background, stocks around the world have just experienced (whether measured in magnitude or persistency of decline) one of the worst three-week periods that many of us can recall in our investment careers.

Again, there are no easy explanations as to what has happened -- there never are (I have consistently written that the investment mosaic is complex and not given to simplicity.)

In many ways, it has been a perfect storm in which a rare combination of circumstances has drastically aggravated the situation: some modest signs of slowing in U.S. and Chinese economic growth, continued political bickering between the Democrats and Republicans (leading to a massive fiscal battle ahead) and, most importantly, fears of a further debt contagion in Europe. JPMorgan Chase's ( JPM) high-profile gaffe added to the market's uncertainty. And even the Facebook ( FB) IPO (previously heralded) was seen as robbing Peter to pay Paul, as investors sold other technology stocks such as Apple ( AAPL) and others to participate in the public offering.

I will try my best to succinctly answer the basic questions of why the market has turned so ugly and whether the current downward spiral will continue. (I could spend thousands of words on these subjects, but I will be brief and attempt to be direct.)

Why Did the Market Plummet?

Europe: Above all, the eroding eurozone has taken a toll on the markets. With the benefit of hindsight, the surprising Greek election (several weeks ago) was the catalyst to the downturn. as fears of a Greek exit from the eurozone have intensified. Investors are now fearful that the debt contagion will spread across Europe.

U.S.: The U.S. economy, though still apparently on track for a muddle-through trajectory of growth, continues to limp along. Several regional ISMs were disappointing (but really not that surprising). Payroll growth remains tepid. Moreover, an uncertain November political outcome, fears of more divisive and partisan leadership (leading to another debt debacle similar to August, 2011) and questions regarding follow-up policy decisions (in an attempt to reduce our burgeoning deficit) haunt investors.

China: China's economy, too, though on tap for +7% to +8% real GDP growth in 2012, seems to be growing ragged around the edges.

What Is the Market Outlook?

Europe: I have argued that there are ample tools to ring-fence Greece. I still believe this to be the case. An ECB cut in interest rates, moves to infuse more liquidity (more aggressive purchase of sovereign debt) and the possibility of implementation of some sort of bank deposit guarantees would go a long way in calming market fears. On the last point, over the weekend Italy's Mario Monti floated the idea of an ECB-backed pan-European bank deposit guarantee program.

U.S.: I remain convinced that domestic economic growth is on track for muddle-through growth (of about 2% real GDP). Housing is poised for a surprising growth spurt in 2013-2014 that could have an important marginal impact on GDP, and other durable expenditures continue to track well below trend line growth (as pent-up demand will be unleashed). The case for buying America remains solid. The U.S. is, by far, the best house in a bad neighborhood. The political tide has started to take a more pro-market and pro-business slant with the steady improvement in the odds that Governor Romney might be elected President in November. Intrade's probability of an Obama victory has gone from 61% to 56% in the last two weeks, and the other polls indicate a tightening Presidential race. Importantly, the swift drop in gasoline prices (and other commodities) provides something of a tailwind for both the American consumer and for U.S. corporate profits.

China: A soft landing is still my baseline expectation for China.

Why I Remain Bullish

I had expected a garden-variety drop (of 5% or so) from the April highs. I was wrong, as a correction far worse developed.

A large share of the responsibility falls on a deepening of investor skepticism and fear concerning the long tail of debt contagion risk in the eurozone. The magnitude of the $4 trillion loss in the world's stock markets must be weighed against the size of Greece (only $325 billion-$350 billion in GDP and about $15 billion of reported corporate profits, which is less than JPMorgan Chase is expected to earn in 2013).

Of course, it's not just Greece that concerns the markets; the message of the market is that broader European contagion fears are on the horizon. As such, the mid-June Greek election is pivotal for markets -- a defeat of the leftist Syriza Party by the conservative and pro-troika New Democracy Party is essential for the world's stock markets to regain their footing.

As I mentioned above, I expect European policy to address and stabilize the region.

The message of the world's stock markets and the message from historically low U.S. and German Treasury note/bond yields speak to the pervasive growth concerns and growing fears (reflected in the flight to safety). As such, the market's decline (in and of itself) will no doubt adversely impact consumer confidence in the months ahead. Spending is threatened. It will be important to closely monitor all U.S. economic data into the summer months in order to gauge the headwinds to growth. Accordingly, this Thursday morning becomes an important data point with flash PMIs from the U.S., China and Europe.

Another negative, as I see it, is that the reallocation out of bonds and into stocks by invigorated retail investors will likely not develop as quickly as I anticipated.

A revitalization in merger and acquisition activity in the months ahead could offset the ambivalent individual investor. Certainly, the rising discounts to private market value and unbelievably low interest rates could catalyze takeover volume if corporate confidence stabilizes.

Takeover activity is exploding this morning. Yahoo! ( YHOO) has sold a portion of its Alibaba stake, AMC Theatres has been purchased by Dalian Wanda Group, DaVita ( DVA) has announced the acquisition of HealthCare Partners, and Eaton ( ETN) has acquired Cooper Industries ( CBE).

Another positive is that the technical situation has gotten stretched to the downside, and many technical indicators are now at levels that marked lows in summer 2010 and fall 2011. Frankly, I have rarely witnessed so many oversold stocks with attractive intermediate-term prospects. Investor sentiment and oversold readings are at levels that historically have led to a turning point. Wall Street strategists' recommended equity allocations are now at the lowest levels (at about 50%) since the generational low. Hedge funds' net long exposure is low and investor sentiment surveys (e.g., AAII) indicate pervasive negativity. Other positive momentum signs include the 10-day CBOE put/call ratios, the McClellan Summation Index and the percentage of NYSE stocks trading above their 50-day moving averages.

In summary, Mr. Market has delivered a rude wake-up call, and the month of May has been a painful reminder of how humbling the investment business can be.

Tactically, I plan to sit tight with my current positions (about 50% net long exposure) and to wait out the increasingly emotional backdrop of fear and loss of investor confidence.

Based on their relationship to corporate profits, sales, private market values and interest rates, stocks are inexpensive and, from my perch, provide a floor to equities. Indeed, relative to interest rates (government and nongovernment), equities have rarely been so cheap. We are back to the elevated risk premiums that existed all the way back in 1975 -- the following two years resulted in +30% and +20% yearly returns in the S&P 500. Risk premiums are even higher than at the generational low in March 2009! A longtime acquaintance (whose input I value) reminded me over the weekend that depending upon which interest rate one uses, "the equity risk premium today is 2.0-2.5 standard deviations above its long-term mean and lies at the third-highest level in the last 52 years."

As the wise man once said, though probably not referring at the time to Mr. Market: "This too shall pass."
At the time of publication, Kass and/or his funds were long JPM and YHOO common/short JPM calls, 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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