By Doug Kass
RealMoney Silver Contributor
8/26/2009 8:41 AM EDT
This blog post originally appeared on RealMoney Silver on Aug. 26 at 8:11 a.m. EDT.
Back in early March, there were signs of a second derivative U.S. economic recovery, the PMI in China had recorded two consecutive months of advances, domestic retail sales had stabilized, housing affordability was hitting multi-decade highs (with the cost of home ownership vs. renting returning back to 2000 levels), valuations were stretched to the downside and sentiment was negative to the extreme. These factors were ignored, however, and the S&P 500 sank to below 700.
To most investors, back in early March, the fear of being out was eclipsed by the fear of being in. Despite the developing less worse factors listed above, bulls were scarce to nonexistent in the face of persistent erosion in equity and credit prices.
It was at this point in time, on RealMoney Silver, in an appearance on CNBC’s “Fast Money,” on “Mad Money” and in multiple appearances on “The Kudlow Report,” I confidently forecast the likelihood that a generational low had been reached.
I went on to audaciously predict that the S&P would rise to 1,050, a gain of nearly 400 points from the S&P low of 666 during the first week of March, by late summer/early fall. I even sketched a precision-like SPDRs (SPY) expectation chart that would reach approximately the 105 level (a 1,050 S&P equivalent) within about six months.
Yesterday the SPDRs peaked at 104.20, within spitting range of my intrepid March forecast of 105, and the S&P nearly touched 1040 in Tuesday’s early morning trading.
Arguably, today investors face the polar opposite of conditions that existed only a few months ago, with economic optimism, improving valuations and positive sentiment.
To most investors, today the fear of being in has now been eclipsed by the fear of being out as the animal spirits are in full force. Bears are now scarce to nonexistent in the face of steady price gains in equity and credit prices.
As if the movie is now being shown in reverse, the bull is persistent, stock corrections are remarkably shallow, cash reserves at mutual funds have been depleted, and hedge funds hold their highest net long positions in many moons.
Stated simply, in the current bull market in complacency, optimism and a boisterous enthusiasm reigns.
As I have written on these pages, the investment debate has morphed in a dramatic fashion from concerns as to whether U.S. economy was entering The Great Depression II to whether the current domestic recovery will be self-sustaining.
The primary question to be asked is, Will the earnings cycle dominate the investment landscape and cause investors to overlook the chronic and secular challenges facing the world’s economies, particularly as the public sector stimulus is eventually withdrawn and paid for and the economic consequences of the massive public sector intervention manifest themselves in the form of higher interest rates and marginal tax rates?
Most now have accepted the notion that due to the replenishment of historically low inventories, extraordinary fiscal/monetary stimulation and the productivity gains from draconian corporate cost-cutting, the earnings cycle is so strong that it will trump the consequences of policy. More accurately, most believe that they can get out of the market before the full effects of policy are felt.
I am less confident as a decade of hocus-pocus borrowing and lending and 35-to-1 leverage at almost every level in both private and public sectors cannot likely be relieved in the great debt unwind over the course of only12 months.
It is important to emphasize that when I made my variant March call, I expected many of the conditions that now exist — namely, a resurgence of economic and investment optimism during the summer to be followed by a multiyear period of weak investment returns. Specifically, I expected a mini production boom and an asset allocation away from bonds and into stocks to be embraced and heralded by investors, who would only be disappointed again in the fall as it becomes clear that a self-sustaining economic recovery is unlikely to develop.
My view remains that it is different this time. Again (now for emphasis), the typical self-sustaining economic recovery of the past will not be repeated in the immediate future for 10 important reasons that will weigh on the economy and markets like the governor that controlled the speed of the Good Humor truck I drove when I was in my teens during the summer:
Cost cuts are a corporate lifeline and so is fiscal stimulus, but both have a defined and limited life.
- Cost cuts (exacerbated by wage deflation) pose an enduring threat to the consumer, which is still the most significant contributor to domestic growth.
- The consumer entered the current downcycle exposed and levered to the hilt, and net worths have been damaged and will need to be repaired through higher savings and lower consumption.
- The credit aftershock will continue to haunt the economy.
- The effect of the Fed’s monetarist experiment and its impact on investing and spending still remain uncertain.
- While the housing market has stabilized, its recovery will be muted, and there are few growth drivers to replace the important role taken by the real estate markets in the prior upturn.
- Commercial real estate has only begun to enter a cyclical downturn.
- While the public works component of public policy is a stimulant, the impact might be more muted than is generally recognized. There may be less than meets the eye as most of the current fiscal policy initiatives represent transfer payments that have a negative multiplier and create work disincentives.
- Municipalities have historically provided economic stability — no more.
- Federal, state and local taxes will be rising as the deficit must eventually be funded, and high-tax health and energy bills also loom.
- Just as I looked over the valley in March 2009 toward the positive effects of massive monetary/fiscal stimulation within the framework of a downside overshoot in valuations and remarkably negative sentiment, I now suggest another contrarian view is appropriate as I look over the visible green shoots of recovery toward a hostile assault of nonconventional factors that few business/credit cycles and even fewer investors have ever witnessed.
Yesterday, the OMB/CBO provided an exclamation point to the secular challenges that the domestic economy faces in forecasting an accumulated deficit of $9 trillion over the next decade (up $2 trillion from the previous forecast just two months ago), and public debt as a percentage of GDP is projected at an alarming 68% by 2019 (as compared to 54% today and only 33% in 2001). Thus far, the drop in the U.S. dollar (influenced, in part, by the mushrooming deficit) has been viewed favorably by the markets, but we must now be alert to a downside probe that becomes a threatening market factor. In other words, what has been viewed positively could shortly become negatively viewed.
A double-dip outcome in 2010 represents my baseline expectation. When the stimulus provided by the public sector is finally abandoned, it seems unlikely to be replaced by meaningful strength or participation by any specific component of the private sector, and the burgeoning deficit (described above) will ultimately require a reversal of policy, leading to higher interest rates, rising marginal tax rates and a lower U.S. dollar. My forecast assumes that the market’s focus will shortly shift from the productivity gains that have been yielding better-than-expected bottom-line results toward these chronic and secular worries.
Even more important, my forecast of a 2010 market peak reflects that the aforementioned nontraditional influences (and the untoward policy ramifications) will, at the very least, yield a broad set of uncertain economic outcomes that (in consequence and in probability) tilt away from a self-sustaining economic scenario sometime in the following 12 months.
Stocks bottom during times of fear. With the benefit of hindsight, the March 2009 lows represented a dramatic overshoot to the downside.
Markets top during times of enthusiasm. I believe that the markets are now overshooting to the upside and that the U.S. stock market has likely peaked for the year.
Doug Kass writes daily for RealMoney Silver, a premium bundle service from TheStreet.com. For a free trial to RealMoney Silver and exclusive access to Mr. Kass’s daily trading diary, please click here.
At the time of publication, Kass and/or his funds were short SPY, although holdings can change at any time.