Where I Now Stand (2012 Edition)

 | Jan 09, 2012 | 1:30 PM EST  | Comments
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This commentary originally appeared Jan. 9 at 7:22 a.m. EST on Real Money Pro – for access to all of legendary hedge fund manager Doug Kass' strategies and commentaries, click here.

Last Wednesday night on "The Kudlow Report" with Sir Larry Kudlow it was Tony Orlando and Dawn ... though really, it was Phil Orlando and Doug tying a ribbon around old Mr. Market!

Phil is a thoughtful strategist, and I have admired him over the years -- in his previous gig at Value Line and now as chief equity market strategist at Federated Investors -- so it was fun being with him last week.

For me, it's been a long year since I have been as optimistic as I am now.

My main point on "The Kudlow Report" was that I am growing more optimistic about the U.S. stock market's prospects, and I am of the view that it's now time to be expanding one's commitment to stocks.

(What follows is in part what I discussed on the show, but I am expanding the core points I made into a broader "Where I Stand Now" missive.)

Twelve months ago we entered 2011 with a wide range of concerns. My worries included, but where not limited to, structural unemployment and mounting fiscal balances (at the local, state and federal levels). I expected a foul mood to weigh on consumer and business confidence and on economic growth. As well, I envisioned a deepening recession in Europe. My outlook for the stock market was negative and I thought stock valuations were vulnerable and would be exposed to these developing headwinds.

Throughout most of the year I suggested that the U.S. stock market would be unstable until volatility quieted down, our political leaders favored compromise over division, European leaders and central bankers adequately addressed a growing debt crisis and until the domestic economic data improved (especially after the sharp erosion in confidence during the late summer).

By contrast, most market observers entered 2011 with far more optimistic economic expectations (of a "normal" self-sustaining economic recovery) and with stock market forecasts that generally contemplated a 15%-20% rise in the major Indices.

For 2011, domestic real GDP growth ended up only about 1.8%, or approximately half the rate of growth that the general consensus anticipated. Corporate profits rose by 16% but most market indices were negative on the year as price-to-earnings ratios contracted.

In contrast, as we enter 2012, the optimistic economic and market consensus of a year ago has turned far more subdued. Reflecting more downbeat economic growth and investor expectations, individual investors (taking another $100 billion out of domestic equity funds) and hedge funds (now at their lowest net long exposure since the Generational Bottom in March 2009) have materially de-risked.

Consensus rarely triumphs in the stock market, and I see 2012 as another year in which the consensus will be wrong.

While I fully recognize the world is imperfect, the blemishes are now well known and, arguably, incorporated in current share prices. More importantly, three of our four concerns (high volatility, a mounting European debt crisis, a weakening domestic economy and the division between the Republican and Democratic parties) are moving in the right direction. And, the fourth, our divided leadership incapable of compromise, might now be coming closer to resolution with a country that appears to be leaning toward the Republican party (I am a Democrat). A close Romney win is now my baseline expectation, and such a political outcome would be more market-friendly than would occur with another four years under President Obama.

I am particularly more optimistic that the U.S. economy's growth trajectory will exceed the expectations of only two or three months ago given the improvement in jobless claims, better-than-expected ISM and PMI readings, strength in automobile sales, etc. Concerns of a double-dip recession have vanished and the outlook for 2012 corporate profits has improved over the past 60 days.

In Europe, political leaders and central bankers are slowly addressing their sovereign debt problems. Though tame and timid in approach at the outset, more "shock and awe" has been employed -- and more is likely on the way. It is my view that the eurozone affliction is moving toward a condition that can be tolerated by the markets (but must always be monitored).

Another market-friendly condition is that central bankers around the world have signaled increasingly accommodative monetary policies. With inflation quiescent, low short-term interest rates are likely to remain for some time.

With better economic growth ahead in the U.S. and the hope for some stability in Europe, a meaningful rotation out of bonds and into stocks is a growing possibility. As I have previously written, U.S. stocks have had an average P/E multiple of 15.3x over the past 50 years, while the yield on the 10- year U.S. note has averaged 6.67%. Today, U.S. stocks trade at only 12.5x with the yield on the 10- year U.S. note at around 2%. Moreover, historically U.S. stocks have been valued at 17x-18x when interest rates and inflation (and inflationary expectations) are around current levels.

Risk premiums (the earnings yield less the risk-free cost of capital) are now elevated and back to levels last seen in 1974 as European sovereign debt issues have accentuated the flight to safety. It is important to note that following the last spike in risk premiums 37 years ago, the S&P 500 index returned +35% and +19% in 1975 and 1976, respectively.

These low stock market valuations (mentioned above) will likely serve as a margin of safety for stocks. I also believe strongly that conditions have evolved over the near and intermediate term that have conspired to favor risk assets in the U.S. over many other areas of the world.

Here are 10 previously mentioned reasons for my optimism that a potential rotation into U.S. assets and out of non-U.S. assets might be forthcoming:

  1. U.S. relative and absolute economic growth is superior to global growth. The U.S. economy, though sluggish in recovery relative to past expansions, is superior to most of the world's economies (with the exception of some emerging markets) in terms of diversity of end markets, quality of global franchises, management expertise, operating execution and financial foundations.
  2. U.S. banks are well-capitalized, liquid and deposit-funded. Our banking industry's health, which is the foundation of credit and growth, is far better off than the rest of the world in terms of liquidity and capital. Our largest financial institutions raised capital in 2008-2009, a full three years ahead of the rest of the world. As an example, eurozone banks continue to delay the inevitability of their necessary capital raises. Importantly, our banking system is deposit-funded, while Europe's banking system is wholesale-funded (and far more dependent on confidence).
  3. U.S. corporations boast strong balance sheets and healthy margins/profits. Our corporations are better positioned than the rest of the world. Through aggressive cost-cutting, productivity gains, external acquisitions, (internal) capital expenditures and the absence of a reliance on debt markets -- most have opportunistically rolled over their higher-cost debt -- U.S. corporations are rock-solid operationally and financially. Even throughout the 2008-2009 recession, most solidified their global franchises that serve increasingly diverse end markets and geographies.
  4. The U.S. consumer is more liquid and stable. An aggressive Fed (through its extended time frame of zero interest rate policy) has resulted in an American consumer that has re-liquefied more than individuals that live in most of the other areas in the world. (Debt service and household debt is down dramatically relative to income.)
  5. The U.S. is politically stable. After watching regime after regime fall in Europe in recent weeks (and given the instability of other rulers throughout the Middle East), it should be clear that the U.S. is more secure politically and from a defense standpoint than most other regions of the world. Our democracy, despite all its inadequacies, has resulted in civil discourse, relatively balanced legislation, smooth regime changes and law that has contributed to social stability and a sense of overall order.
  6. The U.S. has a solid and transparent corporate reporting system. Our regulatory and reporting standards are among the strongest in the world. Compare, for example, the opaque reporting and absence of regulatory oversight in China vs. the U.S. (It is beyond compare.)
  7. The U.S. is rich in resources.
  8. The U.S. has a functioning and forward-looking central bank that is aggressive in policy (when necessary!) and capable of acting during crisis.
  9. The U.S. dollar is (still) the world's reserve currency that is far more solid than the euro.
  10. The U.S. is a magnet for immigrants seeking a better life. This and other factors have contributed to a better demographic profile in our country that has led to consistent population growth and formation of households. (Demographic trends in the U.S. are particularly more favorable for growth than those population trends in the Far East.)

To summarize, I believe 2012 will be a surprisingly good year for the U.S. stock market. I anticipate that domestic economic and profit growth will surprise to the upside, and I am of the view that market valuations will expand (after contracting in 2011). If Europe settles down, the flight to safety of 2010-11 should become a thing of the past this year, and fixed-income instruments could take the brunt of the damage in a potentially large reallocation out of bonds and into equities.

I fully recognize that the slow worldwide economic growth exposes economies and markets to exogenous shocks, but I also think much is discounted in current prices. The world is imperfect and, reflecting that condition, I am not "over our skis" long. Rather, my net long exposure of about 60% is hopefully a balanced and objective reflection of the imperfections that exist today and that constrain valuations -- most notably, a recognition of imprudent domestic policies that have led to our country's fiscal imbalances.

Reflecting my emerging optimism I have been gradually expanding my net long exposure and -- assuming my baseline economic, political and European policy expectations are not altered -- I expect to opportunistically add to my long investments, especially during bouts of market weakness ... which we will surely experience from time to time.

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