Higher interest rates will provide a challenge to a further advance in equity prices. First, nearly every valuation model for the stock market is importantly influenced by the level of interest rates. A meaningful change (upward) in rates reduces the theoretical value of stocks and lowers the risk premium -- the latter being an oft-cited foundation for the bullish case. Second, given the screwflation of the middle class (stagnating incomes and rising costs of the necessities of life), individual investors could move even further away from stocks in favor of the safety of fixed-income investments (especially if rates and bond yields rise). Pension plans, too, may be less likely to invest in stocks if interest rates are rising toward their actuarial assumptions/needs. Moreover, demographics (the aging U.S. population) suggest that post-baby boomers and retirees will grow ever more conservative and could be attracted to the rising risk-free rate of return provided by higher interest rates.

In summary, should the Fed exit quantitative easing earlier than expected thereby producing higher interest rates and a return to natural price discovery in the fixed-income markets (higher yields, lower prices), we have numerous structural, economic and profit risks today that did not exist in prior periods in history. As well, I am fearful that our economy (consumers and businesses) has become addicted to low interest rates and that the act of going off the drug on low rates will be far more painful than is commonly expected.

As a result, it is my view that if Jim's forecast (of rising interest rates) proves correct, stock market valuations' will not expand. In fact, valuations might contract in the face of rising interest rates and the improving alternative of higher yields available in the fixed-income markets.

I look forward to Jim's response to my view expressed in this morning's opening missive and a continued constructive debate between us.
At the time of publication, Kass and/or his funds had no positions in any stocks mentioned, 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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