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"More Nuance Is in Store"
Doug Kass
RealMoney Silver Contributor
1/25/2010
12:01 PM EST


"The best investors are like socialites. They always know where the next party is going to be held. They arrive early and make sure that they depart well before the end, leaving the mob to swill the last tasteless dregs."
-- The Economist, 1986

I aggregate an annual surprise list because outlier events (Black Swans) are occurring with greater frequency, uncertainties will persist and the conventional view is often wrong.
Markets are never black or white, and the investment mosaic is growing ever more complicated. While the determination of market prices and valuation will always be dominated by traditional factors (interest rates, inflation, corporate profit growth, etc.), markets have become far more nuanced and susceptible to disequilibrium in the aftermath of the unparalleled credit-driven boom and in light of complicated political issues and rising geopolitical risks that, arguably, have been all but ignored.


"I fall back on the analogy of a stalled car (the economy) being pulled by a tow truck (government stimulus). The tow truck will want to let the car down one of these days and go on its way. Will the car be able to move on its own? We can only wait and see. I think it's more likely to sputter along than it is to move forward energetically. But at least we don't have to worry any longer about the analogy of 15 months ago: an airplane whose engine has flamed out. A powerless plane in mid-flight presents a far more troubling image than a stalled car."
-- Howard Marks, Oaktree Capital Management (Tell Me I'm Wrong)

It can be argued as we exit January 2010 that the prices on Wall Street remain somewhat ahead of the conditions of Main Street. While the market rally has exceeded all expectations that existed during the first quarter of 2009, a year later we find an economy that is expanding but, as demonstrated in the quote by Howard Marks (above), still heavily reliant on government stimulation -- even despite a zero-interest-rate policy and a lower U.S. dollar that promotes more robust exports.

The unemployment picture remains weak as corporations do without more workers, so the general welfare of the all-important consumer is not much improved. Small business confidence and expansion plans are low because of tax, regulatory uncertainty and limited access to bank credit, so new hires are weak. In contrast to a weak consumer and frozen small business community, large corporations are prospering from draconian cost cuts (but not much top-line improvement), strong (cash-rich) balance sheets and an ability to obtain credit.


Short-Term Outlook: Neither a Bump in nor the End of the Road

Whether the current market decline is a bump in the road, the end of the road or something in between can be debated. I would choose that the most likely short-term outlook is something in between a bump and the end of the road. While I don't see last week's drop as the start of a meaningful correction in equities, I don't see much upside either. In other words, the short-term market might be disappointingly dull and range-bound, with a slight negative bias.

"Good" election news (in Massachusetts) and strong corporate revenue and profits were ignored last week, which is in keeping with my No. 1 surprise for 2010 -- namely, that stocks end first quarter 2010 essentially unchanged from year-end 2009, despite a more than doubling in corporate profits. The year-to-date decline in the S&P 500 is over 2%; a week ago the markets were up by over 3% year-to-date. Investors no longer seem complacent -- the put/call ratio is rising after several distribution days -- and there is an element of panic in the air. From Tuesday's top to now, we have dropped by nearly 5.5%. More important, many stocks have fallen much more from their recent tops to Friday's close: Just look at Caterpillar's (CAT - commentary - Trade Now) drop of 10 points, to $54 a share, or the similar drop for International Business Machines' (IBM - commentary - Trade Now) shares. There are many other examples.


2010 Outlook: A Challenging Year of Subpar Returns

If last year was the time to ride the remarkable values that grew out of the late-2008/early-2009 financial and market panic, 2010 could be a year in which stock pickers (of both long and short ideas) and opportunistic traders deliver the best investment performance -- it might also be a great year to sell premium, straddles and strangles.

It remains my view that the consensus forecasts for GDP, corporate profits, interest rates and for targets on the S&P 500 have a reasonably high probability of occurring but that a number of less benign outcomes remain possible. By the last half of this year, or in early 2011, the consensus forecast of a self-sustaining economic advance could be in jeopardy as there are many potential factors that could contribute to slowing growth. Accordingly, a fully invested position in stocks (which most strategists are recommending) should be questioned. From my perch, a relatively conservative posture seems more appropriate.

I am neither a Cassandra nor a perma-bull; both are attention-getters, not money-makers.

It is also my view that the markets have materially discounted improving macro conditions, and I am holding to my baseline expectation that 2010 will bring a high-single-digit negative return in the major market indices (down 5% to 10%). Valuations are not stretched, we'll likely see an extended period of zero-interest-rate policy (and a curse on cash by the Fed), relatively tame current inflation and inflationary expectations, and a strong year-over-year gain in corporate profits, plus, as an asset class, investors have not embraced stocks in this cycle -- mutual fund stock inflows are negligible; these are among the factors that should cushion the current market fall. The generational low of March 2009 remains very much intact.


It's Different This Time

Regardless of one's short-term view, the nontraditional challenges facing the capital markets are multiple. Most of these factors are valuation-deflating, serving to cap the upside to the U.S. stock market in 2010 and argue against the view that we are embarking upon a normal 40-month-plus upcycle:

Populist policy means more costly regulation and higher marginal taxes for the wealthy and our largest corporations; it also means that small business confidence will remain subdued, as will hiring and expansion plans.

The imbalances between revenue and receipts at state and local finances means higher sales taxes and less service. Municipal employment rolls will contract, unlike in prior economic recoveries.

A still-leveraged consumer facing wage deflation and higher inflation means higher savings and lower personal consumption expenditures. Decades of an aspirational consumer might be reversed -- that is, the definition of a better life could mean more money in the bank and less stuff.

The absence of job growth at small businesses in the face of regulatory and tax uncertainties and the reluctance of large corporations to take on new hires as they seek further productivity gains guarantees that unemployment will remain elevated. With our population growing and our manufacturing base declining (as our global competitiveness deteriorates), from where will the jobs be generated?

The residue of the housing boom is an unprecedented large phantom inventory of unsold homes that will weigh on the slope of the residential real estate market's recovery. While commercial real estate could weather the downturn far better than the bears expect, it, too, will not be a driver to economic growth in the years ahead.

The threat of due bills (higher interest rates and inflation) down the road remain an albatross around the neck of the market's P/E multiple. The U.S. fiscal house is in disorder: Deficits are ballooning, and our educational system, Medicare and Social Security are severely under funded. How long and at what cost can we expect foreign central banks to fund domestic growth?

Geopolitical threats are rising.

The Populist Zeitgeist of Dissatisfaction

I have argued that among the most important challenges to the economy and the markets is a tidal wave of populism. The angry subtext and poor attitude toward big business and the wealthy has rarely been this bad. (Populism threats are woven into many of my surprises for 2010.)

We don't now know how this all pans out.

We don't know whether, after deteriorating approval ratings and the Massachusetts election upset, President Obama will move to a more centrist policy position. (Similar to Ronald Reagan, who had equally low approval ratings in 1983, Barack Obama faces an important State of the Union address this week in which he will outline his plans over the balance of his Presidency.)

We don't know how health care and energy reform will be written.

We don't know who will win the 2010 Super Bowl!

We do know that the depth of our country's fiscal problems could mean that gridlock and legislative inertia are bad this time for the capital markets.

We do know that there is a new sheriff in town for the Republicans as the newly appointed Senator from Massachusetts will likely replace Sarah Palin as an important spokesman, leader and even potentially become the frontrunner for the Republican presidential candidacy in the next election.

We do know that the Jets will win the Super Bowl in 2011.


No More Black Swans ... Maybe a Peking Duck

The cause of a possible downside market move and the least benign outcome for the markets are clear.

When the policies of populism (higher taxes and more costly regulation) are mixed with a number of other nontraditional headwinds (municipalities' disarray, a still-wounded lending mechanism, etc.), the trajectory of economic growth will almost certainly be stunted. I believe these influences and policies could be reflected, contrary to consensus, in a weakening economy by the second half of 2010 -- one of the less benign outcomes I referred to earlier.

These two factors -- (1) public policy that grows from populism; and (2) nontraditional headwinds -- form a potentially toxic cocktail, especially within the context of the size of the market rally of the past eight months and under the possible setting in which higher interest rates begin to offer competition to stocks. "

(in www.realmoney.com)