Kass: Curbing My Enthusiasm

This column originally appeared on Real Money Pro at 8:40 a.m. EDT on July 3.

NEW YORK ( Real Money) -- Strategic adjustments:

  • I have slightly adjusted my S&P 500 fair market value downward from 1455 to 1430 -- the market is still about 5% undervalued.
  • A trading range of 1290 to 1430 seems probable for the balance of 2012.
  • Against the anticipated trading range above, reward and risk remain basically in balance (70 S&P points up and 70 S&P points down).

Changes

Let's investigate what fundamental, sentiment, valuation and political changes have occurred since my last fair market value update five weeks ago.

  1. U.S. Economy: Deteriorating. Domestic economic data have been disappointing relative to my modest expectations. First-quarter 2012 real GDP growth came in a tad under 2%, and second-quarter 2012 real GDP growth will be challenged to match the previous quarter. We seem destined to muddle through this year, closer to 1.5% growth compared to our previous below-consensus expectation of 2.0% growth. Payroll growth seems stuck at below-consensus levels, and the rate of growth in U.S. manufacturing activity is decelerating at a more rapid pace. On the other hand, some major positives for worldwide growth include global easing, the drubbing in commodities (a tax cut to the consumer and a prop to corporate profit margins, which argues in favor of an extended period of easing) and the improvement in the U.S. housing market (the sector represents the greatest divergence in economic series relative to consensus). Business and consumer confidence, which was still elevated as recently as last month seems destined to drop in the months ahead amid EU concerns and U.S. political concerns (the fiscal cliff).
  2. Europe's Economy: Negative With Little Visibility. Despite some steps in a positive direction achieved at the recent Brussels meeting, a lot of structural issues and heavy lifting remain. More importantly, the bigger issues of insured bank deposits, eurobonds, fiscal integration and a larger scale for both the ESM and ESFS were not discussed in any detail. Here is the extreme negative case for the eurozone, as told by Byron Wien. This week I expect the ECB to cut its target rate by 25 basis points and its deposit rate paid on reserves by 10 basis points, in line with general expectations.
  3. China's Economy: Heading Toward a Hard Landing. A soft landing no longer seems to be the strong base case scenario as there are emerging question marks over the strength of the region's economy and the validity of its data.
  4. Corporate Profits: Consensus Forecast Is Now in Jeopardy. While only one-sixth of aggregate S&P profits come from Europe, the region's economic outlook is ambiguous at best. I am now skeptical of consensus eurozone real GDP growth expectations of a modest reduction in 2012 and a small increase in 2013. The U.S. remains the best house in a bad neighborhood: with 1.5% to 2% real GDP growth and less than 2% inflation, nominal GDP growth is likely to be a subpar 3% to 4% this year, translating to about 5% to 6% sales and profit growth. (Of course, most realtors will tell you never buy the best house in a bad neighborhood.)
  5. Investor Sentiment and Expectations: Still Low. Most classes of investors have de-risked, which is not surprising considering sluggish worldwide economic growth, still elevated unemployment and the ongoing eurozone crisis. Add in the JPMorgan Chase (JPM) large derivative loss and the Libor manipulation of Barclays (BCS) and other banks, and a show-me attitude will likely continue for some time. Low trading volume, dominated still by high-frequency strategies, and the absence of inflows into domestic equity funds are a reflection of investor indifference. Stated simply, stocks remain an unpopular asset class, and the reallocation out of bonds and into stocks looks to be a more distant event.
  6. Political: The Outlook for the November Election Remains Uncertain. The Supreme Court's healthcare decision has likely further divided our dysfunctional political leaders/parties. As a result, an August 2011-like impasse on the fiscal cliff is more likely. A potential positive to the capital markets (based on the general belief that a Republican administration will be more business- and market-friendly) is that the Republican Party is gaining some traction as compared to several months ago.

Update

Today I have updated the probabilities of the four outcomes to reflect the six changing conditions listed above. In large measure, the worsening situation in both Europe and the U.S. is leading me to further reduce my calculation of the S&P 500's fair market value from 1455 to 1430, which is still about 5% above the cash level at Monday's close of trading (1358):

  • I am keeping the chances of the two tail events -- namely, a reacceleration of U.S. growth and a U.S. recession in 2013, at 5% each.
  • I am increasing the probability of sub-1.5% 2013 real GDP growth from 25% to 35%.
  • I am reducing the likelihood of my baseline, muddle-through scenario (defined as 2013 real GDP growth of between 1.5% and 2.0%) from 65% to 55%.

My base case of muddling through, with a slightly better than 50/50 probability, yields an S&P 500 price target of 1540, far higher than my fair market value calculation of 1430 and well above cash (1358). The probability of muddling through, however, has been ratcheted down and will likely move still lower in the next month, due to a continuation of a weakening domestic economy and the bandages applied to the eurozone. Below-consensus growth (scenario No. 3 below), which is now accorded an increased 35% probability (the second-highest), yields an S&P 500 target of 1290, below both the current level of S&P 500 cash (1358) and well under my 1430 fair market value estimate. (These two most likely outcomes account for a 90% probability.)

S&P cash closed yesterday at 1358. In all likelihood, I expect the S&P 500 to be contained within the range of 1290 and my fair market value of 1430 over the balance of the year, representing an almost perfect balance between reward and risk. This yields a generally underwhelming and less-than-compelling investment equation. Taken literally, this would mean that there are about 70 S&P points of risk and an equal amount of S&P points of potential reward. (In other words, there will be a premium on individual stock selection over market risk-on/risk-off decisions in the months ahead.)

As I have repeatedly written, my methodology, though appearing precise, recognizes the difficulty of attaining investment precision given the numerous moving parts (economic, interest rates, sentiment/psychology and exogenous factors) in its calculation. It is intended more as a thoughtful guideline (of reasonable expectations/outcomes) than an exercise that should be taken literally. (Input your own probabilities and outcomes to produce your own market expectations.)

Scenarios

Below are the criteria and methodology I use to evaluate the S&P 500 and upon which I conclude that fair market value is approximately 1430, or about 5% above Friday's closing quote of 1358.

Scenario No. 1 -- Economic Reacceleration Above Consensus (probability stays at 5%): The pace of U.S. economic recovery reaccelerates to above-consensus forecasts (3%+ real GDP growth) based on pro-growth fiscal policies geared toward generating job growth; corporate profit margins being preserved (with low inflation and contained wage growth); interest rates remaining low; and durable spending (housing and autos) recovering sharply as pent-up demand is unleashed. The $550 billion fiscal cliff is whittled down to only about $150 billion (subtracting less than 0.5% from 2013 real GDP) as Governor Romney wins the Presidency and the Republican Party gains control of the Senate and regains the House. Europe stabilizes (and experiences a shallow recession), and China has a soft landing (with GDP growth tracking in excess of 8%). There is no QE3. S&P 500 profit estimates for 2013 are raised to $110-$113 per share. Stocks, valued at 15.5x under this outcome, have 26% upside over the next nine months. S&P target is 1725.

Scenario No. 2 -- Recession (probability stays at 5%): The U.S. enters a recession precipitated by a loss of business and consumer confidence, producing a fall in manufacturing output and personal consumption expenditures. The Democratic Party regains the White House and the Senate, but the Republicans maintain control of the House of Representative. The schism between the two parties persists. Partisanship leads to rancor during summer debt-ceiling deliberations (instituted because of slowing nominal GDP) similar to that of August 2011. Confidence deteriorates further, and the housing market seizes up as bank lending becomes more restrictive when the fiscal cliff is not remedied/addressed (the hit to GDP is -1.5% to -2.0%). QE3 is instituted but fails to contain the economic weakness. A series of European bank failures and EU sovereign debt defaults contribute to a deepening European recession and a hard landing in China and India. S&P 500 earnings estimates for 2013 are materially reduced to $75 to $80 per share. Stocks, valued at 11.5x under this outcome, have 35% downside risk over the next nine months. S&P target is 890.

Scenario No. 3 -- Below-Consensus Economic Growth (probability goes from 25% to 35%): The U.S. experiences a disappointing sub-1.5% real GDP growth rate, Europe experiences a medium-scale recession, and China's economic growth disappoints modestly relative to expectations. QE3 is initiated and has a modestly favorable impact on aggregate growth. Obama regains the presidency, and the Republicans control Congress. The fiscal cliff is reduced by less than half (to $275 billion to $350 billion). The S&P 500 profit forecast for 2013 is reduced to levels slightly below 2012's results and below consensus at $98 to $100 per share, as corporations' pricing power is limited and profit margins are pressured. Stocks, valued at 13.0x under this outcome, have 5% downside risk over the next nine months. S&P target is 1290.

Scenario No. 4 -- Muddle Through (probability goes from 65% to 55%): The U.S. muddles through, with 1.5% to 2.25% real GDP growth, and the European economies suffer a modest (but contained) business downturn. China's and India's economies grow in line relative to consensus forecasts. There is no further quantitative easing. Obama regains the White House, and the Republicans control Congress. The fiscal cliff is reduced by half (to $275 billion). S&P 500 profits for 2013 trend toward a range of $107-$109 per share as some modest margin slippage occurs (coincident with escalating inflationary pressures). Stocks, valued at 14.25x under this outcome, have 13% upside over the next nine months. S&P target is 1540.
At the time of publication, Kass and/or his funds were short SPY common and 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.