This commentary originally appeared at 8:37 a.m. EDT on Oct. 15 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.
"Logical consequences are the scarecrows of fools and the beacons of wise men."
-- Aldous Huxley
I remain cautious and plan to stay conservatively positioned over the near term.
While I recognize that being right about the direction of markets and being logical and sound of analysis may not always be a perfect marriage, today we face an unhealthy combination of a widening disconnect between elevated market valuations and current and prospective weakening fundamentals.
Over the last few months, central bankers have re-inflated the wedge that separates weak fundamentals from high market prices.
Whether it is the Fed's open-ended QE3 and extended forward interest rate guidance, or the European Central Bank's unlimited securities purchase program, robust asset markets are an integral part of policy attempts to counter tail risks and deliver economic growth and jobs.
By artificially inflating asset prices above levels justified by sluggish fundamentals, these two central banks hope to calm market concerns, ignite animal spirits and trigger the wealth effect. And their actions are contagious....
[I]nvestors should not get too carried away.
There is a limit to how far and how long prices can deviate from fundamentals. This is particularly the case when central banks, acting without the support of other government entities, do not have sufficiently-refined tools to secure good and sustainable economic outcomes....
[I]nvestors' romance with the "central bank put" should not be unconditional or everlasting....
Central banks should be respected. And they can certainly counter air pockets, but not forever.
-- Mohamed El-Erian, CNBC.com column
As relayed in the above comments by El-Erian, at its core, the bullish view is based on a Soma-induced lunar eternity in which investors worship at the altar (and effectiveness) of more easing and the ever easy money provided by central bankers coupled with the downside protection afforded by a global monetary easing put.
While the potential exists for resolution of the many issues highlighted in this column by early 2013, risk (particularly relative to reward) has been unusually heightened over the near term and through the balance of 2012.
How many goodly creatures are there here!
How beauteous mankind is! O brave new world,
That has such people in't!
-- William Shakespeare, The Tempest
Similar to the character of the ultimate outsider, "John" in Huxley's seminal work, Brave New World, I am finding it hard to fit in with the generally optimistic and bullish World State these days.
"'A gramme is better than a damn,' said Lenina mechanically from behind her hands. 'I wish I had my soma!'"
-- Aldous Huxley, Brave New World
Investors face the risk of a non-Soma reality in the months ahead.
Recent indicators of business confidence highlight that the policies of our leaders (in both parties) in Washington, D.C., are inhibiting employment growth. In turn, the domestic economic recovery remains subpar. This has produced a serious challenge to corporate profit growth in this year's second half and potentially for 2013.
Until recently, market participants have been looking through the global economic and earnings lethargy and have relied on the global monetary policy put to give fuel to the upside and to provide investors with the confidence that the downside was protected.
During the last few weeks, however, the market's uptrend has appeared to reverse, and the S&P 500 now threatens to break previous support levels.
The tug of war between borderline irresponsible fiscal inaction and expansive monetary policy defines the current market condition.
The upside can come from a combination of:
- a Romney presidential win next month (Republicans are generally viewed as business- and market-friendly);
- an acceleration of domestic economic growth; and/or
- progress on the fiscal front in late 2012/early 2013.
The downside can come from a combination of:
- the assertion of geopolitical risks (in the Middle East), which would elevate oil prices;
- a worsening domestic economy;
- less-than-expected corporate profit growth; and/or
- an inability to address the fiscal cliff.
Investors and traders will need to react quickly to these factors as they play out in the months ahead.
"The man who promises everything is sure to fulfill nothing, and everyone who promises too much is in danger of using evil means in order to carry out his promises, and is already on the road to perdition."
-- Carl Jung
Below are my 10 baseline expectations that form the basis of my concerns and expectations for a weak U.S. stock market (which might put us squarely on a journey toward the road to perdition).
1. Macro malpractice: The wrong (monetary) medicine is being applied to the world's economies. Global easing is a blunt instrument operating through circuitous and dubious channels. It is a policy that will not necessarily elevate animal spirits, raise the price of risk assets or stir real economic growth. Having already taken interest rates to near zero, more cowbell will do little to offset balance sheet deleveraging and other structural (not cyclical) headwinds (e.g., high unemployment) and the need for the implementation of fiscal austerity around the world.
2. Unwholesome (policy-dependent) and sluggish economic growth continues: Domestic high-frequency economic data will continue to point toward 1.5% to 2.0% fourth-quarter real GDP. But this is unwholesome and not self-sustaining growth as it is reliant upon massive doses of liquidity. Moreover, income disparity is the natural outcome of quantitative easing, creating an imbalanced recovery that has and will continue to favor the wealthy. The continued threat of screwflation of the middle class raises social issues and will likely serve as a drag on economic prosperity, importantly influence and define election outcomes and continue to underscore the retail investor's disaffinity toward investing in the U.S. stock market.
3. An "unfavorable" election outcome: The Democratic Party will likely retain (in narrow victories) the presidency and control of the Senate. This result may be viewed as hostile toward business and investment markets.
4. The leadership deficit and fiscal cliff: There will be no movement toward addressing the fiscal cliff until early 2013, as there currently exists no political will (on the side of either party) to overcome partisan differences. Almost any outcome will involve a fiscal drag to next year's economic recovery.
5. Tax uncertainty: Not only will business capital spending plans be delayed by the lack of visibility in tax policy and the fiscal cliff but the likely rise in effective tax rates (on dividends and capital gains) in 2013 could result in liquidation of stocks in 2012. (In theory, the tax rate on dividends will increase from 15% to as much as 39.6% plus the 3.8% surtax on Obamacare.)
6. Band-Aids in Europe: There will likely be little progress made in the eurozone's continuing sovereign debt crisis. Britain's Nigel Farage puts the EU's plight clearly into perspective in a weekend interview:
You only have to open your eyes to see the increasing violence and division within the EU, which is caused by the euro project.
Spain is on the verge of a bailout, with senior military figures warning that the army may have to intervene in Catalonia.
In Greece people are starving and abandoning their children through desperate poverty and never a week goes by that we don't see riots and protests in capital cities against the troika and the economic prison they have imposed....
The last attempt in Europe to impose a new flag, currency and nationality on separate states was called Yugoslavia. The EU is repeating the same tragic mistake.
Rather than bring peace and harmony, the EU will cause insurgency and violence.
7. China's economic growth falls short, and the EU's economy sputters: China, the world's driver of growth, will likely disappoint relative to consensus. The Eurozone's economy has low expectations -- and even those low expectations will likely disappoint.
8. Possible technical breakdowns: The S&P 500 will likely breach 1425 support. Two important groups, financials and technology, pose fundamental risks. Financials face continued margin compression from zero interest rate policy. Among other issues, the technology sector is transitioning from open to closed systems such as Apple (AAPL) in secular move away from personal computers, AT&T (T) and Verizon's (VZ) -- two large service providers -- networks have been built out, the weakening of global economies is hurting consumer spending for tech gadgets, and the move to the cloud is disruptive to technology sales.
9. The profit cycle erodes: Reported third-quarter profits and forward earnings guidance will disappoint relative to consensus expectations.
10. Valuations full: Stocks have not discounted the challenging earnings picture for third quarter 2012, fourth quarter 2012 and full year 2013. (My below-consensus estimate is $97.50 per share in S&P 500 earnings for next year.) The S&P trades at 14.7x. This is very close to the five-decade average of 15.1x, and during most of the last 50 years, the U.S. did not face the numerous structural headwinds with which we are confronted today.
Again, for emphasis, I am not a perma-bear or a Cassandra; I am simply responding to the fundamental and technical realities of the marketplace.
If the U.S. stock market falls in line with my expectations, I am optimistic that there will be plenty of developing opportunities. Indeed, even in the recent modest 3% drop from the recent highs, I have already begun to uncover selected and new long investment ideas, including Yahoo! (YHOO), Sourcefire (FIRE), Fusion-io (FIO) and Bristol-Myers Squibb (BMY).
As we enter this year's final three months, the one thing I am certain about is that uncertainty will characterize the investing, economic, profits and political backdrop.
Accordingly, I continue to expect the balance of the year to be one in which there is a lot of volatility.
Hopefully, this will provide us with a chance to deliver good investment returns through opportunistic trading, a strategy that I have begun to employ more aggressively in recent weeks.