Risk/Reward Ratio Improves

 | Nov 05, 2012 | 12:30 PM EST  | Comments
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TBT

This commentary originally appeared at 8:35 a.m. EDT on Nov. 5 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

I have been concerned that the economic, fiscal, geopolitical and earnings cliffs would be in attendance over the balance of the year and into early 2013, serving to weigh down the U.S. stock market.

I still remain deeply concerned about the earnings cliff, but recent signposts suggest a somewhat more reduced concern over the economic, geopolitical and fiscal cliffs is in order. These signals, combined with central bank easing around the world, suggest that the rationale behind a meaningful market downside has been removed and that the market's risk/reward has improved.

The S&P 500 closed at 1415 on Friday, which is precisely my fair market value calculation -- with the exception of my increased fair market value to 1485 in May, my methodology has been reasonably accurate this year.

Reflecting the increased likelihood that my base-case election result will occur on Tuesday, with the Democrats easily retaining the presidency and (less easily) the control of the Senate, I see the downside to the S&P 500 over the remainder of the year limited to about 1390-1400. The upside to the S&P 500 should be 1450-1470. (See Scenario No. 1 in "More on the Business of Politics" below.)

In other words, year-end risk is about 20 S&P points, and reward is approximately 45 S&P points, for a better than 2-1 reward over risk.

The Global Economic Cliff Is Disappearing

While I am still in the camp that expects subpar global growth, recent indications are that a self-sustaining economic recovery is in place and that the recessionistas are dead wrong.

Indeed, among the developed countries, the U.S. is shining:

U.S. economy: High-frequency economic releases during the past four weeks suggest a slight reacceleration in domestic growth that should continue into 2013 -- of course, this is dependent upon how meaningfully and quickly the fiscal cliff is addressed.

The positives are accumulating:

  • Jobless claims are declining, and jobs growth is accelerating. October payrolls increased to a net 171,000 jobs (compared to an estimate of only 125,000), private sector hirings were the most since February (helped by an unexpected increase in manufacturing hiring), and the previous two months' hirings were revised much higher.
  • Both the manufacturing and service sector PMIs have risen to above 50.
  • Housing has clearly bottomed and is recovering in price and in activity -- arguably, the U.S. residential real estate market is embarking on a multiyear and durable recovery.
  • The domestic automobile market is exhibiting a stronger recovery than many anticipated, and the 10.5-year age of the cars on the road suggests still-large pent-up demand.
  • Retail sales are humming. October consumer confidence rose to 72.2, up from 68.4 in September -- the best since February 2008.
  • Hurricane Sandy was just a terrible tragedy for many, but the rebuilding effort will result in incremental growth in the first half of 2013.
  • Inflation and inflationary expectations are stable.
  • Short-term interest rates are anchored and zero (though, as I will comment on later in today's opener, longer-term interest rates are likely to rise).

China's economy: The October non-manufacturing index rose from 53.7 in September to 55.5. This strong data follows the October China manufacturing index, which, for the first time in three months, rose above 50. Further, China's industrial production accelerated in September, and retail sales grew at the best pace since April.

We must now conclude that the eight-quarter slowdown in China's economic growth is over and that a slight acceleration in growth is occurring. It is now unlikely that meaningful monetary easing moves will be needed or employed in China, though monetary policy remains friendly. This is a clear positive for equities, as we can now scratch off a Chinese hard landing as a concern because the accumulated data are convincing. Importantly, a modestly strengthening Chinese economy reduces the risk that global economic growth will hit a wall or stall speed.

Eurozone economy: The EU is still mired in a recession with no signs of improvement next year, but expectations are low (so no surprise to risk markets). On the positive side, the ECB will continue to provide liquidity as policymakers finally have begun to work together in an attempt to form a banking union that provides a deposit insurance program and some sort of central authority that will assess countries' abilities and intentions to meet deficit goals.

I am not under the illusion that the heavy lifting is over -- it has just started -- and that there won't be substantive and painful bumps along the road toward structural change.

A Reasonable Fiscal Cliff Compromise

Scenario No. 1:

A relatively comfortable Electoral College win by Obama in which the Democrats keep control of the Senate -- 40% probability (baseline expectation): The fiscal drag is about 1%-1.5%, and 2013 real GDP growth is 1%-2%. Republicans briefly oppose Democratic policy but quickly acquiesce to Democrat policy initiatives. Stocks are range-bound and have limited downside (

-- Doug Kass, "More on the Business of Politics"

The zeitgeist, expressed in Frank Bruni's editorial in The New York Times over the weekend (and elsewhere), is that the embittered and losing party will claim that their candidate didn't get a fair shake and will hunker down to fight and foil the victor. It is generally assumed by most that political dysfunction, in a country being steadily diminished by it, will ensue as the fiscal cliff approaches in January, 2013, but, as most recognize, a continued and partisan alternative doesn't get us any closer to solving problems that grow it bigger and bigger with time.

Dismissed by many as an out-of-character response in addressing the fiscal cliff is a potentially more optimistic scenario expressed in the writings of Bruni:

There's an opportunity here, as we hit the reset button, for Obama to begin a second term by lavishing his attention on areas of general bipartisan agreement or for Romney to begin a first term with a focus on that same territory. It exists. Both parties acknowledge the need for tax reform and agree that we have to figure out a way to keep the spending on Social Security, Medicare and Medicaid in check, especially as the population ages. Both parties accept that a competitive America is an educated America, and would like to see the country make strides on that front.

So before we surrender to our worst fears about Tuesday's winner or re-litigate our complaints — many warranted, some overblown — against him, shouldn't we first adopt a posture of support and see if he steps forward as a consensus-building problem solver rather than a hostage to special interests and partisan passions? Don't we owe that to him, and even more to ourselves?

-- Frank Bruni, "The Far Side of Acrimony," The New York Times (Nov. 3, 2012)

As I discussed in Friday's opener, I am increasingly confident that Obama will retain the presidency by a comfortable margin and that the Democrats will keep control of the Senate. The size of the Democratic mandate could serve as a framework result for a less contentious and acrimonious debate over the fiscal cliff (just as a large Romney win would also accomplish).

The bipartisan Group of Eight senators are already working on a legislative framework that would offset some of the automatic defense cuts, patch the alternative minimum tax, prevent a 25%-30% reduction in Medicare and extend the debt ceiling. This would provide the president and the Congress some breathing room in order to develop some legislation aimed at reducing the federal deficit. In opposition will be a more conservative House of Representative, who will not easily abandon the Ryan plan, which seeks to reduce long-term mandatory spending and preserve the Bush tax cuts.

It is said that our leaders rise during crisis. Though they didn't rise -- in fact, they fell -- in last August's debt negotiations, the variant view is that our politicians have learned a lesson. And as I have conjectured, I am more optimistic (or maybe more hopeful) that, at least for the time being, the hatchet might be buried somewhat and more sensible and constructive discussions could be chosen over partisan ones.

In conclusion, some fiscal drag should be expected next year, but, if the election is not a cliffhanger, the fiscal cliff may not be quite the fall that I (and others) might have feared it would be.

Geopolitical Cliff Ebbing

It appears that the risk of an air strike by Israel on Iran's nuclear facilities has been recently reduced. Sanctions have already hurt Iran's economy. Social unrest has accompanied rapid inflation and a currency that has depreciated by nearly 50%.

Political change appears imminent, and the current leaders of the Iranian government even appear to be willing to engage in discussions possibly aimed to negotiate a pullback in its nuclear program. The last thing on Iran's agenda may be a nuclear bomb. Some have even speculated that the country is no closer to being able to produce a nuclear bomb than two years ago. Meanwhile, the rulers of some of Iran's allies (e.g., Syria) are under siege and are increasingly isolated in the face their own domestic issues.

But the Earnings Cliff Remains

I remain concerned about the prospects for U.S. corporate profits, but one out of four cliffs ain't bad.

Nonetheless, the earnings cliff is still an overriding concern of mine, and it limits the upside to U.S. equities.

Investment Conclusion

The risk/reward ratio has improved for equities, but the risk/reward ratio for my short bond position might have improved even more. With business picking up in the U.S. and China coupled with the possibility of less fiscal drag in 2013 -- the ingredients for an earlier-than-expected increase in interest rates might now be in place.

I could even envision an economic growth scare by midyear 2013.

The dichotomy between the confidence and spending of the consumer and of the corporate sector is striking.

As mentioned previously, the U.S. consumer has been resilient -- retail sales and confidence has picked up -- but the uncertainty over tax and regulatory issues has weighed on the business sector. Capital investment and hirings have suffered. But even without the impetus in the business sector, the current run rate of real GDP exceeds 2%.

If the fiscal cliff is addressed and some confidence is restored, a potentially juicy cocktail of pent-up demand in both the consumer and business sectors could be combustible.

In summary, there remains a lot of uncertainty (especially of a profits kind), but there is now reason to believe that there is less market downside (and more hope of upside) to the U.S. stock market than I formerly expected.

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