Mr. Market Keeps Singing a Happy Song

 | May 20, 2013 | 12:30 PM EDT  | Comments
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This commentary originally appeared at 8:56 a.m. EDT on May 20 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

This morning's opening missive summarizes my previous and current market views and attempts to deliver a mea culpa as to why I have been so wrong in my outlook.

Upon reflection, being wrong in my outlook has been a gross understatement -- as in my career, I rarely have been as mistaken as I have been thus far in 2013.

Valuations Rise in Lieu of Little Real Economic Improvement

The most frustrating part of this year was that my macroeconomic concerns have been relatively accurate. What I missed was the market's willingness to revalue stocks higher even in the face of flat sales, only about a 2.5% increase in corporate profits and with the vulnerability to profit margins at 75% above the long-term average.

The S&P 500's P/E started the year at 13.7x and now stands at over 16x. In part, this revaluation has been a function of first-quarter earnings having come in slightly better than expected -- not by much, maybe about $0.75 a share. If we assume that S&P earnings this year will be about $103.00 a share (or about a $3.00 upward revision from my prior baseline estimate), in theory this should produce only about a $48 lift ($3.00 x 16) in the S&P 500's value, not over 200 points that has been already recorded.

If you look at the methodology of my fair market value calculations for the S&P 500, I had mistakenly thought (in all four scenarios) that P/E multiples would remain below the five-decade average (of approximately 15.0x) given the projected weakening domestic economic growth, China's decelerating growth trajectory, Europe's lingering structural debt problems and a general continuation in the global deleveraging process, among other issues.

Money Printing Is Viewed as a Panacea

With the S&P now at 1670, the market advance has been dramatically more than might be justified by a modest rise in profit expectations. The answer, of course, is a global monetary easing that has reduced the fixed-income alternatives, resulted in the perception that tail risk in Europe has been all but eliminated and put a damper on risk asset price volatility. Some of this I had expected, but the magnitude of the stock market response to the weight of lower interest rates and liquidity had not been anticipated by me in the face of the aforementioned challenging top-line revenue prospects and a generally lackluster profit picture.

The market has been indifferent to my thesis of slowing economic and profit growth. Also, with the Fed, the Bank of Japan, the ECB and the Bank of England all in, the lift to valuations from easing -- I had thought (again, incorrectly) -- should have been completed a while ago. As I have noted in the past, at least in the U.S., the benefits of quantitative easing are fading; they might even begin to produce a negative net-net impact on aggregate growth as the savings class gets robbed.

The Free Lunch

Current monetary policy is an easy way out, removing the near-term need for our leaders in Washington, D.C., to make more difficult decisions through the implementation of responsible fiscal policy.

There are unintended consequences and, I thought, no free lunch. Not only does zero interest rate policy dismantle retirees' income from savings, it forces them into risky assets at the wrong time of their lifecycle because of the lack of alternative investment opportunities.

Yet, the market has not cared.

Too aggressive monetary policy is not trickling down into the real economy -- rather it is serving to widen the schism between the haves and the have-nots, which was reflected in Wal-Mart's (WMT) weak quarter.

Yet, the market has not cared.

In essence it has been and remains my view that the Fed is pushing on a string, shouldering too much of the responsibility to sustain growth and that money printing is likely to fail to revive the real economy.

I incorrectly thought that market participants would react negatively to the domestic (real) economy's failure to revive even in the face of unprecedented monetary stimulus, similar to when investors abandoned the gold market at its price peak in 2011 and/or when an Apple's (AAPL) share price top was reached at $700 in 2012.

Money printing aimed at producing higher inflation (which could allow the world economies to grow out of their debt problem in a painless way) worked after World War II, owing to the reconstruction and pent-up demand in the system. But the framework this time is completely different and, I felt and continue to feel, could do more harm than good.

Market Optimism Revives

While I was growing more negative this year, other investors have grown more positive, seeing equities as the sole alternative in a zero interest rate world.

According to Merrill Lynch's May global fund manager survey (230 investors with $660 billion in assets under management) released last week, hedge funds are at their highest net long exposure in seven years. Clearly, this dominant and influential investor class (as well as other classes who are joining in) has dismissed my concerns of slowing nominal GDP growth and the challenge to corporate profits.

The Good and the Bad

There have recently been some bright spots. Oil prices have slipped, jobless claims have trended lower, and the outlook for employment has improved. The labor force is expanding somewhat, and temporary jobs growth has turned up but possibly for the wrong/bad reasons (related to Obamacare).

Nevertheless, I have maintained my bearish market view owing to multiple forces at work that had suggested to me that first quarter 2013 would likely mark a peak in U.S. real GDP for the year. This expected moderation of economic growth, I had thought, would produce weak nominal GDP that would limit corporate pricing power, jeopardizing already-inflated profit margins and pressuring corporate profits to well under consensus expectations.

I remain concerned, but thus far investors are totally indifferent.

Housing: Hedge funds and other corporate and institutional investors have gobbled up homes for investment, creating the appearance of a more vibrant residential market than might actually exist. This has served to prop up home prices, which, in turn, could serve to turn away first-time homebuyers (who continue to be haunted by little wage improvement and a still relatively sluggish labor market). I have argued that construction only represents about 3% of U.S. GDP, and, as such, I didn't think (and still don't think that) the housing market could provide enough leverage to get U.S. real GDP growth to exceed a tepid 2% rate. I continue to expect a pause in an anticipated durable multiyear recovery in housing.

Jobs: While unemployment claims have begun to improve, this volatile series likely benefited from continued Superstorm Sandy reconstruction. Moreover, the improvement appears to be mostly in temporary and lower-paying jobs. As I discuss later, a strengthening U.S. dollar reduces the competitiveness of U.S. corporations and will likely govern growth in the labor force.

Oil prices: After a several-month-long drop in gasoline prices (see above), the price of crude oil seems to have stabilized and has started to move higher over the past two weeks.

Federal budget deficit: A near-term improvement in the U.S. budget deficit could be bad news for the sequestration, as both Democrats and Republicans become less willing to negotiate anything in the budget. This could portend a big debt-ceiling debate/fight.

Currencies: The profound weakness in the Japanese yen reduces the competitiveness of other countries. Specifically, it will likely temper U.S. manufacturing export growth and the profits of some of our largest international corporations that serve non-domestic markets. This could stall U.S. jobs growth and capital spending expenditures and plans. In its extreme, the Japanese experiment could have worldwide deflationary ramifications, resulting in a 2014 recession and lower profits and profit margins, even despite the magnitude of global money printing.

Quantitative easing: Last week, Appaloosa's David Tepper was optimistic on the markets based on the Fed's continued printing. The Fed has printed about $1 trillion, and this year, the U.S. exchanges' market cap has risen by $2.75 trillion. That is quite a lot of bang for the Fed's buck! In other words, Tepper says that the Fed's printing press is going into stocks -- and will continue to do so. But the stock market wealth build already well exceeds the expected 2013 EPS growth -- plus the $1 trillion of fresh money printing. To me, Jon Hilsenrath's Wall Street Journal column a week ago was a shot across the bow to prepare investors for halting steps in printing. I expect that the Fed could pause/taper in the second half of 2013. If so, interest rates will rise, providing a headwind to interest-rate-sensitive domestic economic sectors and result in more competition to equities.

To summarize, despite my continuing concerns, I have been deeply wrong of view as my focus has been on factors that market participants have totally ignored or dismissed.

Stated simply, I sang a sad song of lackluster fundamentals while Mr. Market sang a happy song of global easing.

Mea culpa.

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