Kass: My 'Fast Money' Recap

This column originally appeared on Real Money Pro at 7:50 a.m. EDT on July 10.

NEW YORK ( Real Money) -- On Friday I was on the "Fast Money Halftime Report" with Scott Wapner and the gang.

Let's go to the tape!

In today's opening missive I am going to outline and expand on my comments from the "Fast Money Halftime Report" in order to fully explain where I stand today.

I have recently downgraded my previously more optimistic expectations for the U.S. stock market, reflecting the confluence of the following four factors, which form a potentially toxic market cocktail.

  1. Global growth is slowing, and the corporate profit outlook is worsening. The rate of global economic growth is decelerating worse than I had anticipated, and the outlook for corporate profits in 2012-2013 is deteriorating. The U.S. is experiencing its third pause in the subpar recovery that began in 2009, the eurozone is in recession, and economies in important growth countries China and India are slowing down.
  2. Monetary easing is losing its effectiveness. It is increasingly clear that the benefits from monetary easing are waning. Responsible fiscal policy now holds the key to economic success, especially in the face of unique structural headwinds and the continued deleveraging of the consumers' balance sheets.
  3. U.S. and eurozone leaders remain inert and dysfunctional. Unfortunately, our policymakers are inert, dysfunctional and divided. I was hopeful that concessions would be made and partisanship would have been dropped by now in order to implement much-needed pro-growth fiscal policy. This has not happened, and as we move ever closer to the November elections (and the fiscal cliff at year-end), the likelihood of compromise seems more and more remote as election paralysis has set in. European leaders are even less focused on real change than our representatives in Washington, D.C. The recent Brussels summit provided only baby steps, not the bold initiatives needed to resolve the EU's deepening sovereign debt crisis.
  4. A negative feedback loop is hurting confidence and markets. The major risk is that a negative feedback loop, reminiscent of August 2011, has been ignited. Already, consumer and business confidence is suffering, and jobs creation is moderating (and the potential exists for a further downward spiral in the months ahead). This is not a healthy state given the vulnerable domestic economy, which is now experiencing subpar growth of only about +1.5% in real GDP. Bottom line: There is little margin for error, as even a minor external shock or policy mistake could easily trigger recession.

While the upside to the U.S. stock market might be limited by a deceleration in the rate of global economic growth and disappointing corporate profits, so might the downside be limited as valuations are not unreasonable. Investor sentiment is poor, and investor expectations are modest as many classes of investors have de-risked. This could also serve to cushion a more meaningful drop in the U.S. stock market.

I want to briefly expand on the above talking points.

It is becoming increasingly clear that global easing is losing its marginal benefit and is waning in influence and that the onus of future economic and corporate profit growth lies squarely on the shoulders of fiscal policy.

Unfortunately, the likelihood of inaction and the associated policy uncertainty (fiscal, taxes, regulation) are about to weigh down corporate results (possibly for some time to come).

In the U.S., dysfunctional politicians are unable to put their differences on the back burner in order to address the fiscal cliff and to implement thoughtful, creative and impactful pro-growth fiscal initiatives.

In the eurozone, hard-hitting, potentially painful and politically risky fiscal initiatives are being delayed in favor of more band aids (and monetary easing). The overseas markets are starting to see through those temporary patches. Already, the Euro has given up all its gains since the late June economic summit in Brussels. As well, yields on Spanish and Italian bonds are again back up to pre-summit levels.

Before the year began (and up to last month), I was hopeful that this would be different (i.e., that policy would be less uncertain and that economic growth would reaccelerate). But as we move ever closer to the November elections, any movement away from the currently divided and divisive behavior is increasingly unlikely. The behavior and inertia of our leaders in Washington, D.C., has been a downer for business and consumer confidence, and now the earnings picture is quickly eroding in the face of an unsurprising deterioration in confidence and an accelerating negative feedback loop.

With certainty, the rate of growth in the domestic economic recovery is growing more ambiguous. For the first time in over three years, the ISM manufacturing index slipped below 50 in June. Especially conspicuous has been the weakness in exports, which reflects a global slowdown. Domestic orders, too, are falling off as backlogs are dropping and delivery times are shortening. At the same time, the service industry's PMI has fallen from a high of over 62 four months ago to only 51.7 in June, the lowest reading since 2009. This is taking a toll on the jobs market, with the jobless rate stuck at 8.2% and with payroll increases averaging less than 100,000 per month over the last three months. The one bright spot is the U.S. housing market, which is providing some support to the economy after acting as a drag since 2007.

Despite clear signs of slowing growth, earnings forecasts have yet to be reduced.

Consensus forecasts (implicit in $100-plus-per-share 2012 S&P 500 earnings) are for about 5% year-over-year growth in profits in second quarter 2012 and for about 6% growth in this year's second half. As sales gains slow coincident with a deceleration in worldwide economic growth and as policy inaction breeds more uncertainty, these profit projections are now in jeopardy. Already, there are warnings signs from companies in a wide range of different industries, including Nike ( NKE), Procter & Gamble ( PG), Caterpillar ( CAT), Ford ( F), Informatica ( INFA) and Seagate Technology ( STX).

My direct communications with the managements of companies I research enforce the notion that growth is slowing and profit expectations are too high.

Despite trillions of dollars in global easing since 2008, the domestic ISMs and other leading economic indicators are signaling that growth is slowing relative to expectations as structural headwinds, continued deleveraging and policy uncertainty are producing a tepid recovery.

The major categories of retail, technology, industrial and financial are all beginning to experience misses relative to consensus.

June retail sales were generally soft relative to consensus, with the high end notable in its weakness. Surprisingly, weakening gasoline prices have had little positive impact on the consumer.

The technology sector, which is particularly exposed to a European slowdown and the strength in the U.S. dollar, has hit the skids, with unit growth expectations for personal computers, smartphones, chips and disk drives being revised lower as IT spending expectations are being continually downgraded.

The industrial sector's earnings are increasingly vulnerable to slowing global growth, and numerous companies have guided lower in recent weeks.

Profits in another important group, financials, are being weighed down by a generational low in interest rates. Net interest margins are being continually pressured by massive global easing as the industry typically holds an imbalance of rate-sensitive assets over rate-sensitive liabilities. Moreover, bank earnings and returns on invested capital are also being lowered by limitations on leverage and a contraction in allowable business lines (based on regulatory reform). Other diversified financial institutions such as insurance companies are suffering from low interest rates as their portfolios' yields are pressured.

In summary, we are at a critical juncture for the U.S. stock market and for the global economy.

Market optimists mostly cite that valuations are undemanding. There is merit to this view, but valuation has historically been a poor timing tool. Given the lower profits prospects for 2012-2013 and the persistent and growing policy uncertainty in the U.S. and eurozone, we should recognize that the traditional valuation relationships of stock prices relative to the economy, earnings, interest rates, inflation, replacement cost and private market values have lost some of their historic relevance.

I am confident that, in the fullness of time, current conditions will ultimately improve -- it is the challenge of anticipating that improvement that will likely be the key to delivering superior investment performance in the period ahead.

But for now, I view the most prudent strategy as erring on the side of conservatism by maintaining above-average cash reserves.

And for now, opportunistic trading remains my central focus.

Confidence in longer-term investing is something we can regain when there is more clarity than today.
At the time of publication, Kass and/or his funds were long PG and F, 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.