The Loss of Market Innocence

 | Jun 24, 2013 | 12:00 PM EDT  | Comments
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This commentary originally appeared at 8:37 a.m. EDT on June 24 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

"It's you who are telling me; opening my eyes to things I'd looked at so long that I'd ceased to see them."

-- Edith Wharton, The Age of Innocence

Risk happens fast.

We all knew that last week was coming, that last week was inevitable.

I (prematurely) cautioned in January-February (and in the ensuing months) that this market day would come -- a day in which the liquidity, so necessary to recover the world's economies from the Great Decession, would come to an end. Or, at the very least, I suggested that its ending would begin to be discounted well in advance of the triggering event.

I worried that a period lies ahead in which both stock and bond prices fall at the same time, breaking the correlation of the last few years.

I argued that tepid global economic growth would render the recovery vulnerable to policy mistakes and exogenous events and/or black swans.

I warned that the Fed's quantitative easing was losing its impact, that trickle-down was helping only a small segment of the U.S. population (i.e., the wealthy) and that the liquidity provided by QE was widening the disconnect between stock prices and the real economy.

I questioned the wisdom of expanding valuations in the face of slowing economic growth, a challenging profit landscape and the diminished impact of central bank easing.

I expressed the argument that structural headwinds were being ignored (over the cloak of zero interest rates and massive liquidity). Despite over four years of easy money, the U.S. was left with still-punkish sub-2% real GDP growth, far from the well-balanced and self-sustaining growth that was sought after by extreme and unprecedented loose monetary policy.

I wrote that the investment world was flat and not even the U.S. was an island and uncoupled from the rest of the globe.

I worried about the eurozone and its incomplete reform initiatives and still-recessionary economic existence.

I was skeptical that China's economy could continue its world-leading growth rates amid empty cities and developments and questionable/sketchy reporting of economic data.

I observed that the market's ramp was exaggerated by high-frequency-trading programs tied into price momentum strategies and ETFs (particularly those of a leveraged kind) that rebalance with frequency.

I opined that the interest rate cliff was what investors and traders should be worried about, even more than the much-feared fiscal cliff.

Finally, I advised that there was ample evidence (second-quarter 2013 estimated real GDP of only +1.8%) that the Fed was pushing on a string and that when investors understood that condition, markets faced an "aha moment."

I concluded that as the market ramped, the reward vs. risk equation had meaningfully deteriorated. Leadership changes, I suggested, were occurring in a market whose character and complexion was changing -- this changing terrain has historically and typically provided a forceful market warning.

I projected that volatility would emerge out of complacency and that most investors, depending on their time frames, should err on the side of conservatism by expanding cash reserves and by keeping trading/investing positions smaller than usual.

I favored ProShares UltraShort Russell2000 (TWM) over iShares Russell 2000 Index Fund (IWM) and preferred being short SPDR S&P 500 ETF Trust (SPY) to being long.

And I emphasized that trading sardines (opportunistically) would become my investment mantra over eating (and investing in) sardines over the balance of 2013.

"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing."

-- Former Citigroup (C) CEO Chuck Prince (2007)

My concerns were dismissed by the markets.

Despite no improvement in the consensus corporate profit outlook, the P/E multiples of the S&P forged ever-higher, starting the year at 13.7x and exceeding 16x a week ago. (Note: It is now down to 15x.)

Even some of the most strident bears recently turned bullish in an apparent acquiescence to the market's nearly uninterrupted run-up. Most conspicuous in a bearish-to-bullish transformation has been Dr. Nouriel Roubini. Gluskin Sheff's David Rosenberg even pulled in his ursine outlook. So did many others.

Hedge funds, benefiting from the highly profitable (but levered) carried trade, took their net long exposure to multiyear highs, and retail investors slowly but deliberately and consistently added to their investments in domestic equity funds.

Meanwhile, a generational low in interest rates took 10-year yields to 1.60% (as recently as early May), as investors grew confident that the Fed would be bond buyers ad infinitum.

By late May, I was so concerned that I sold out of all the equities I purchased back in 2009 at or near the generational bottom.

Corporate revenues and profits will decline across the board. P/E multiples will contract. Europe will be worse than America. China will have any number of Kung Fu moments and the world is going to get really tough once again. The drying up of liquidity will affect everything and then one will feed off the other. The worsening of global economies will impact the markets. The decline in the markets will affect the economies. The downward spiral will feed upon itself.

Prepare yourselves. You will hear more crap than can be imagined during our next leg down. "The technicals says this," and "The buying opportunities are wonderful" and "An investor must stay the course" and all manner of baloney that will be heaped so high that not even Dagwood could eat this sandwich.

-- Mark J. Grant, Southwest Securities

Last Wednesday the Fed Chairman stopped the music when he announced that QE could be terminated by mid-2014.

Investors have been riding in a limo, but the driver, Ben Bernanke, just told us we are about to run out of gas.

Is our investment world going to come to an end as we know it?

No.

But we must begin to grow accustomed to taking the subway.

The trip will likely be a much less smooth and a far more bumpy voyage.

And, at times, it might even become dangerous as we ride through more disturbing surroundings.

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