Is Everyone Too Bearish?

 | Aug 23, 2011 | 12:00 PM EDT  | Comments
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This commentary originally appeared on Real Money Pro on Aug. 23 at 9:15 a.m. EDT.

In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

-- Warren Buffett

Public opinion polls and talking heads are not substitutes for thought.

Sentiment (as measured by what the dominant investors are doing, not what the investment writers are saying) -- defined by the de-risking of hedge funds (back to 2009 levels) and the wholesale abandonment by individual investors out of domestic equity funds (over the last five years and especially during the month of August) -- is profoundly negative.

The bearish cabal is out front and chest-thumping. (One bear, in particular, I will discuss in my next column, is particularly conspicuous).

Back in April, CNBC had trouble finding a bear; two months later, the bulls are the rarest of breeds in the media and on the floor of the New York Stock Exchange.

Over the course of the last week, uber bearish Hedgeye Risk Management CEO Keith McCullough has appeared in the media at least three times. The lynx-eyed Steve Roach, the non-executive chairman of Morgan Stanley Asia, was yesterday's "Squawk Box" guest host. This morning Marc Faber of The Gloom Boom & Doom Report is guest hosting "Squawk Box."

Flight-to-safety trades, gold and bonds have become the investments du jour, with gold's spot price close to $1,900 an ounce (or 40% above its one-year moving average of $1,380) and with the Treasury's 10-year note at 2% (providing a negative real return).

Nevertheless, the principal legs of the market's stool -- 1. fundamentals (the hard economic numbers are shaky but not terrible, and corporate balance sheets and income statements are rock solid); 2. sentiment (as measured by fear, VIX, de-risking and mutual fund outflows); 3. valuations (attractive relative to interest rates, inflation and inflationary expectations); and 4. credit metrics (nonthreatening) -- suggest that equities are undervalued on an intermediate-term basis.

The nontraditional structural issues that I have written about voluminously (the screwflation of the middle class, structural unemployment, a housing market burdened by a large shadow inventory of unsold homes, fiscal imbalances, political partisanship and gridlock providing a legislative impasse, the tail risk of the last credit cycle manifested in weak housing and a fragile European banking system) are well-known and on the front page today. Also, the ambiguity of economic indicators that I highlighted over the past nine months, which has been ignored by strategists and money managers for so long, is now well-recognized, and that uncertainty is now feared by most investors.

Meanwhile, the void created by de-risked hedge funds and the fifth consecutive year of domestic mutual equity fund outflows has been picked up by stock-price-momentum-based algorithms and trading strategies populated by high-frequency traders that have zero knowledge of what they own. This has created market havoc and a randomness in and exaggeration of price movements, providing even more fear on the part of investors in a Catch -22 environment.

The recognition of the above secular issues, the market's volatility, the policy action/inaction aimed at remedying some of these factors and an opaque and ill-quantified European bank crisis have stunned investors, resulting in a schmeissing of stock prices in a negative feedback loop not experienced since 2008-2009.

Fear is pervasive (an understatement!), and even pros are acting like amateurs. How else to explain my dinner at Nick and Toni's last night in East Hampton with my friend/buddy/pal, Joe Zicherman, who, when active professionally, was an enormously successful stock broker to the stars in Hollywood? At last night's dinner, Joe and I stupidly positioned his iPad on our table as we fixated on the CNBC application and watched with bewilderment every $0.50 change in the S&P futures and every $5 change in the price of gold. (Futures were down 4 handles then and are now up 18 handles!) These sort of idiotic things don't happen at or anywhere near market tops; they occur at or near market bottoms.

In the investment business the rearview mirror is always clearer than the windshield; it's important to  recognize that stocks have gone nowhere in a decade.

But, as Omega's Lee Cooperman mentioned to me a few weeks ago, in the course of American history, out of crisis comes leadership and constructive change. Here are 10 changes, again, with the assistance of Lee, that I endorse:

1. Establish term limits for all our representatives.

2. Limit government spending. Set a specific limitation on the annual gains in spending to be less than the increase in consumer price index.

3. Develop a comprehensive jobs plan.

4. Fix housing. Over 15 million homeowners are underwater with their mortgages, the shadow inventory of unsold homes is a drag on a housing recovery, and we must find a way to find a way to reemploy over 2 million former housing-related workers. We need a Marshall Plan for housing. I would suggest that the Obama administration reach out to the two most knowledgeable and smartest guys in the residential real estate markets, Eli Broad and Bob Toll. I would have them all meet in a locked room with Fed Chairman Ben Bernanke, Treasury Secretary Geithner and President Obama (and his economic team).

5. Raise taxes on the rich. Put a three-year income tax surcharge (of 10% to 15%) on incomes above $500,000.

6. Create a health care czar and tackle our health care industry's delivery and costs.

7. Mean test entitlements, freeze entitlement payouts and gradually increase the social security retirement age to 70 years old.

8. Exit Afghanistan and Iraq immediately. More effectively rationalize the defense budget and provide returning soldiers full tuition to vocational schools and colleges as they have sacrificed much.

9. Build infrastructure. Set up an infrastructure bank, and place the money saved on defense into a massive build-out and improvement of the U.S. infrastructure base.

10. Create energy self-sufficiency. Develop a comprehensive plan designed to rapidly develop all of our energy resources.

I continue to see a successful test between 1130 and 1150 on the S&P 500 (above the lows of two weeks ago) with the following buffers of support that could insulate the markets from further declines:

• There will be no double-dip (the negative feedback loop is hurting business and consumer sentiment, but other hard economic indicators don't signal a recession).

• Interest rates are anchored at zero.

• Inflation and inflationary expectations are contained.

• Strength of corporate balance sheets and trailing profits are strong.

• Valuations are reasonable.

• 55% of the all S&P stocks now yield more than the 10-year U.S. note.

• Risk premiums (the difference between earnings yield and corporate bonds) are near record levels.

• Investor expectations are limited.

• Hedge funds have de-risked. (The ISI Hedge Fund Survey reports net exposure down to 45.8%, the lowest level in two years.)

• The wholesale abandonment by the individual investor ($30 billion withdrawn two weeks alone).

• The possibility of a large reallocation out of low-yielding bonds and into stocks.

Everyone is too bearish.

Doug Kass writes daily for RealMoney Pro, a premium service from TheStreet. For a free trial to RealMoney Pro and exclusive access to Mr. Kass's trades and market commentary, please click here.

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