Kass: The Lion's Share

This column originally appeared on Real Money Pro at 8:40 a.m. EDT on July 23.

A month ago, I was speaking to the legendary Ira Harris (one of the most influential Wall Streeters extant back in the day when he ran Salomon Brothers' Chicago office), who mentioned that he could not remember a time during his investment career when there was so much uncertainty as there is now.

In other words, there exists, as Sir John Mauldin points out in his commentary this week, more than the usual lurking "lions in the grass" (and in the open fields) these days.

In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.

-- From "That Which Is Seen and That Which Is Unseen," an 1850 essay by Frédéric Bastiat (hat tip John Mauldin)

As John wrote over the weekend, most lions are readily seen -- they are known, in front of us and are usually anticipated. The lions in the grass and their distant cousins, the more random black swans, which have been spotted with a frightening frequency over the past decade, however, are not readily foreseen -- those are the scariest and the most market-upsetting. They spring upon us suddenly, unexpectedly (and some of them even inhabit my annual surprises lists), sometimes taking off an arm or a leg or causing our investment portfolio to plummet in value.

While those lions in the grass are grazing somewhere -- one possible grass inhabitant might be the adverse implications of the current U.S. drought -- let's review the visible lions that limit the upside and the downside to the U.S. stock market.

Core Market Challenges That Limit Upside

More than at 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. I speak, by the way, not with any sense of futility, but with a panicky conviction of the absolute meaninglessness of existence that could easily be misinterpreted as pessimism. It is not. It is merely a healthy concern for the predicament of modern man.

-- Woody Allen

Fundamentals: Top-line growth is moderating, and there is a limit to how long corporate profit growth (and margins) can be sustained. The U.S. bond market is delivering a more bearish economic vision than the U.S. stock market. While the U.S. economy stands tall relative to the other developed economies, any realtor will tell you not to buy the best house in a bad neighborhood.

Eurozone: These ferocious lions are running amok in Europe. They represent the greatest threat to the well-being of the equity markets. Last week, in a vote of no confidence, the euro has hit a two-year low against the U.S. dollar.

Central banks: With interest rates near zero, U.S. monetary policy is waning in its influence and could be pushing on a string.

Politics: Governor Romney is considered by most market participants as pro-market and pro-business relative to the incumbent, but President Obama's lead in the polls continues. He remains the favorite -- at this point in time, it's his election to lose.

Geopolitical: The Middle East is heating up and so is the price of crude oil.

Core Market Positives That Limit Downside

"Disaster has a way of not happening."

-- Byron Wien, vice chairman Blackstone Advisory Partners

Fundamentals: Second-quarter 2012 results have failed to indicate that an imminent drop in corporate profits (or margins) will occur. Despite some falloff in the top line, corporations have controlled their fixed costs and continue to operate profitably even as the rate of global economic growth decelerates. Balance sheets are rock-solid, with reams of cash and liquidity. The CRB Index has fallen by nearly 15% from June, a tax cut to the consumer and a potential preserver of corporate margins. The residential real estate market has bottomed (in sales activity and price) and appears on the launch path of a durable, multiyear recovery. The U.S. stock market remains the best house in a questionable economic and investment neighborhood.

Eurozone: Though not caged, these lions can still be domesticated by the region's central bankers and leaders through forceful policy. Most importantly, their whereabouts are well-known by the markets.

Politics: While the fiscal cliff is feared, there might be upside to expectations as even our dysfunctional leaders must recognize that a repeat of August 2011 will crush business and consumer confidence, our markets and our economy. History shows that our leadership rises in times of crisis. (Let us hope that Senator Schumer and others are listening.)

Central banks: A broad-based (and market-friendly) global easing promises to be with us for some time to come.

Sentiment and expectations: Investor sentiment remains subdued, mired in a lost decade for stocks, the Great Decession and structural disequilibrium in the jobs market. Investor expectations have been dulled by the May 2010 flash crash, two large drawdowns (in 2000-2002 and 2008-2009) and numerous scandals (Madoff, Stanford, Peregrine, Lie-bor, etc.) and trading gaffes (at JPMorgan Chase ( JPM) and elsewhere). Retail investors and hedge-hoggers have de-risked. Large pension plans are skewed toward low- or no-yielding fixed income and have not yet balanced back into equities. Frightened by the past, these (anti-speculative) conditions suggest that, with so many turned off to equities (and turned on to fixed income), the pain trade is to the upside.

Valuations: P/E ratios are undemanding relative to inflationary expectations, interest rates, earnings and private market values. Most conspicuously, risk premiums are back to mid-1975 levels, a period that was followed by outsized gains in the senior averages.

How to Trade a Trading-Sardine Market

Many of my most successful hedge fund friends have made their fortunes in buying and holding -- namely, by discovering investment acorns that rise into mighty oaks. They contend that, regardless of the environment, there will always be those opportunities.

Many of these hedge-hoggers have prospered by bottoms-up stock picking and have often downplayed the macroeconomic backdrop.

They might be correct -- and for many it has paid mighty dividends -- but I contend, by contrast, that the unique conditions that exist today make the harvesting of those great investments ever more difficult. Indeed, there are numerous fundamental, valuation, sentiment and technical factors that support the notion that both the upside and downside might be limited.

In his seminal book, Margin of Safety, hedge fund manager Seth Klarman tells an old story about the market craze in sardine trading. One day, the sardines disappear from their traditional habitat off the Monterey, Calif., shores, so the commodity traders bid the price of sardines up, and prices soar. Then, along comes a buyer who decides that he wants to treat himself to an expensive meal and actually opens up a can and starts eating. He immediately gets ill and tells the seller that the sardines were no good. The seller quickly responds, "You don't understand. These are not eating sardines; they are trading sardines!"

The 11 factors discussed above that on one side limit the market's upside and on the other limit the market's downside seem to almost offset each other -- ergo, we might be locked in a trading range. These conditions are likely set to deliver what I have termed in the past a trading-sardine market, not an eating-sardine market.

Investment Conclusion

In summary, the U.S. stock market is populated by an unusual amount of visible (fierce and not-so-fierce) lions in the open and likely several lions lurking in the grass.

For now, the pride of lions is holding the markets at bay, and reward vs. risk appears in balance.

As a result, there appears to be no real trend nor is there likely to be one over the short term and into the fall. Instead, as I recently mentioned, a range-bound market confined between 1,300 and 1,420 on the S&P 500 seems to be a reasonable expectation for the balance of the year. (Friday's close of 1360 is a relatively balanced reward relative to risk.)

My strategy has been to be 20% to 30% (long or short) on either side of market-neutral, depending on my assessment of the near-term outlook.

In the trading-sardine market I envision, I plan to continue to trade the range and rent with a nimble, albeit conservative, short-term view over the next few months, rotating into sectors, as we recently did in the Market Vectors Oil Services ETF ( OIH), and into individual securities as the opportunities develop.

More serious money is typically made by investing rather than via short-term trading. But, for now, as I look at the investment portion of my portfolio, I plan to be patient while waiting for the right pitch.

Even though there are, no doubt, conspicuous lions and less visible lions in the grass, as we move closer to the election, there will likely be more clarity and a meaningful trend will hopefully fall in place later in the year.

That trend might even produce an eating-sardine market and a good backdrop for investing.

Hopefully, at that point in time, we will have the courage to be the king of the investment jungle.

At the time of publication, Kass and/or his funds were long JPM, 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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