Second-Half Summit

 | Jan 17, 2012 | 11:00 AM EST  | Comments
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This commentary originally appeared at 8:35 a.m. EST on Jan. 17 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

Last week, I enumerated 10 reasons why I expect the market to rally. I anticipate the year to proceed with a steady beat, building up to a crescendo by third quarter 2012.

The consensus rarely triumphs in the equity markets.

As I remarked in "Where I Stand (2012 Version)," a year ago, almost no one anticipated that if the consensus for S&P 500 operating profits (at around $96 a share) was met (as it was), then P/E ratios would contract by over 15% in 2011 and the leading indices would be flat to down.

To most, it seems incomprehensible, particularly given multiple headwinds in the U.S. and in Europe, that market valuations can expand this year -- and, as I have submitted, that the S&P 500 can approach its March 2000 high of around 1550 this year and even exceed its previous all-time high reached on October 2007 of around 1576 by early 2013.

Domestic and non-U.S. concerns are known, will not likely be discounted again and, importantly, will likely diminish in consequence. Markets typically fall or rise (sharply) on the unexpected. Our fiscal imbalances and those of our counterparts are more appreciated than they were a year ago, when there was almost universal agreement (by the Fed, Wall Street strategists, etc.) of a normal duration (to history) and self-sustaining economic cycle. That optimism was incorporated in a consensus 15%-20% gain for the U.S. stock market and proved incorrect. Good times (late 2010) morphed into worsening times last year, as economic growth expectations failed to be realized and were marked down. With the benefit of hindsight this provided a strong headwind to stock prices in 2011.

Fortunately, most of the economic disappointment is now behind us, and fourth-quarter 2011 real U.S. GDP growth will exceed 3%. Pent-up demand for durable spending, a gradual improvement in the jobs market and improving business and consumer confidence will unleash steady improvement in economic growth in 2012 (albeit, less than previous recoveries).

Though many, including my friend/buddy/pal John Mauldin (and others) hold a dire EU outlook, it remains my view that Friday's Standard & Poor's downgrades of European sovereign debt will have only a limited immediate impact here and abroad. (It was telegraphed, already priced in and it has likely been already discounted.)

Monday's European equity markets closed near their highs; our futures are substantively higher; French, Spanish and Italian bond yields dropped; and the euro has advanced smartly against many currencies (up by nearly 1% against the U.S. dollar at the time of this writing) -- it is not out of the question that the reaction will not be dissimilar to the reaction to the U.S. downgrade during the summer. On the positive side, S&P's European ratings change could serve as a catalyst to hard but coordinated fiscal and political decisions -- the heavy lifting is still ahead -- that will ultimately produce more positive outcomes and stability.

As I have previously written, European "tame and timid" will, in the fullness of time, become "shock and awe," as Europe's leaders and central bankers eventually do what has to be done. (Courtesy of Zero Hedge, here is Goldman Sachs' and Morgan Stanley's assessment of the downgrades). February's liquidity add through the long-term refinancing operation facility will likely stabilize the debt crisis in Europe. And the ECB is already thinking more "shock and awe" based on a report in The Wall Street Journal this morning. In the fullness of time, Greece (which all now know is already bankrupt) and its lenders will agree to deeper writedowns of debt, as that country remains in the EU. More is to come.

Finally (and anecdotally), CNBC's announcement that Michelle Caruso-Cabrera has been named the station's first chief international correspondent is probably a surefire example that the eurozone's problems have been discounted and could even lose their market influence in the months ahead. Similar to the bugs on the CNBC screen (which exhibit the price of gold/silver, Italian bond yields or whatever else is deemed by the network as "topical" and "important" to investors but have actually already lost their relevance), Michelle's appointment is quite possibly another rearview mirror indicator that has been materially discounted.

Negatives have been sufficiently discounted. The S&P 500 now trades at only 12.2x estimated 2012 earnings consensus, 3 multiple points below the last 50 years' average (when the yield on the 10-year U.S. note approached 6.70%) and nearly 7 multiple points below times in history when interest rates and inflationary expectations were similar. The consensus, upbeat 12 months ago, is now downbeat, as vividly illustrated by this interview with Pimco's Bill Gross who, along with many others, ask now whether there will be another economic/debt apocalypse. But how will the apocalypse occur?

With "the new normal" of de-leveraging, re-regulation, de-globalization and slowing economic growth now embraced by consensus, investors' expectations are lowly ebbing, as individuals and institutions have materially de-risked in response to growth assumptions. Economic growth expectations, which surprised to the downside in 2011, have been recast to lower expectations as a baseline view and, as such, have been materially discounted. Surprises could come from the upside in 2012 to that baseline and lowered view. (Last night already saw two surprises, as the German confidence index exhibited the largest one-month rise in history and China's GDP rose better than expectations. The later report resulted in the largest upside move in the Chinese stock market since late 2009.)

A market crescendo will build throughout 2012. I expect that U.S. share prices will slowly climb the wall of worry in the first half of the year as the European crisis stabilizes, owing to a growing commitment by European leaders and central bankers to do whatever is necessary to avoid the unimaginable. At the same time, high-frequency domestic economic statistics will likely continue to gradually improve, led by surprising strength in housing and automobile industry sales.

Prospects for a U.S. political regime change will embolden investors as the year unfolds. A business- and market-friendly Republican leadership will look increasingly likely to replace the current administration as the year progresses. A crescendo-like buildup in consumer and business confidence will likely unfold.

Interest rates remain low, and inflation stays quiescent. A market-friendly Fed (and a worldwide global loosening of the monetary reins), a still-large manufacturing output gap and a "not too hot, not too cold" jobs picture (which will contain wage inflation and protect corporate profit margins) could contribute to a crescendo-like buildup in stock valuations. It is not inconceivable that the contraction (around 15% in valuations in 2011) will be entirely reversed in 2012. This expansion in multiples, coupled with near-10% earnings growth, could produce an outsized and totally unexpected 20%-25% gain the S&P 500 this year.

In summary, investors were nonplussed in 2011, but the outlook for 2012 is likely to turn positive by the second half.

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