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2006-11-02 :: Bear Market Analysis

I’ve cut/paste an interesting analysis from Doug Kass, a frequent contributor to CNBC and The Street.  He is a tried and true bear, so I thought you all might find his analysis compelling.  The contrarian in me says that with all of the small investors now jumping in to buy the large caps / index-related stocks, it is time to get cautious.

We’ve been tightening stops under some of the stocks that have had nice runs over the last couple of months, so if the market does pull back significantly, we’ll automatically generate cash.  Stop Losses are not an exact science as the price you enter the stop at is unlikely to be the place where you sell; generally its lower (sometimes a lot lower), since all the stop does is authorize the brokerage to sell the stock once the price drops to or below your price.  If the stock opens down 5% due to some unexpected news, you will sell at that 5% down point instead of at your stop loss price.  The good news is that it gets you out of the stock before it drops to a 10% loss.  We’ve had a few hit already and have been reinvesting some of the cash and leaving some in money market for future purchases if/when the market does pull back.

Anyway, here are Doug Kass’ thoughts on the coming bear market (his thesis):

Making the Bear Case

A virtual cornucopia of optimism based on the resumption of another Goldilocks has investors partying almost like it was 1999. As Barron’s Alan Abelson remarked several weeks ago, the market seems like investors are at a perpetual happy hour. Complacency has become profuse, while fear and doubt have nearly been driven from Wall Street. To state the obvious, a sharp decrease in the yield on intermediate-term and long-term bonds coupled with a substantial reduction in the price of energy products has trumped increased evidence that the rate of economic growth is decelerating while inflationary pressures stubbornly persist. Despite the bears’ incessant protestations, equities have now risen in nine of the first 10 months of the year and, as of this date, have climbed by more than 11% (including dividends).

The Bears’ Burden of Proof

For now, good and bad news is good news for equities, and the burden of proof lies squarely with those who have had an ursine view. The market’s recent treatment of Wal-Mart’s (WMT) same-store-sales weakness as a one-off is symptomatic of an equity market that is interpreting even the most disturbing data points as a net positive in what I interpret as a copious complacency. It might sound arrogant (like I’m talking my short-selling book), but I believe that the current rally is being propelled more by money than logic, and more by emotion (and performance anxiety) than fundamentals. Unlike CNBC’s Larry Kudlow, who says the economy is “the greatest story never told,” I say that the equity market is “the greatest story ever sold.” Stated simply, the future of the economy does not look like Goldilocks to me. My baseline economic view is for a lumpy and uneven period of growth. Not a recession, but what I call blahflation (blah growth and stubbornly high inflation), a setting corporate managers and investment managers will find hard to navigate. The benefits of a material decline in energy prices have propped up consumer spending, which was beginning to waver in the spring. Nevertheless, in light of a number of variables (not the least of which are geopolitical in nature), confidence that energy prices will remain subdued is what we all hope for. But in all likelihood, the price of energy products will remain volatile, with an upward bias. My economic concerns continue to be focused on my expectations of a protracted housing downturn, the vulnerability of the consumer, stubbornly high inflation and the prospects for eroding corporate profit margins and disappointing earnings in 2007-08.

A Hard Landing for Housing

Generational lows in interest rates and unprecedented speculative activity formed the basis for housing’s disproportionate role in economic growth this decade.

  • The real estate industry has been responsible for 40% of the job growth since 2001.

  • The rise in home prices has provided for 70% of the increase in household net worth since 2001.

  • The increase in consumer spending and real estate construction spending has contributed to 90% of the growth in GDP since 2001.

Because of housing’s extraordinary economic contribution, the downturn that is being experienced will have much broader ramifications on our economy than generally expected. It will be particularly hard felt in California, the epicenter of the egregious use of creative mortgage vehicles. From a national perspective, the loss of construction, mortgage-lending and real estate jobs will weigh significantly on the next six months of jobs reports. At the height of the housing market, consumers were borrowing almost 10% of their incomes as mortgage equity withdrawals. This cash-out refinancing added 1%-1.5% to GDP per year. Such refinancing has dropped in half and, despite lower interest rates, is in free fall. Only a year into the downturn, home prices are experiencing unprecedented sharp declines, particularly in the previously strong coastal markets. Many argue that regional influences are skewing these home-price drops. The price declines are being understated, as they do not incorporate builder and broker incentives: The next several months will be an important tell.

Rumors of Slowing Inflation Are Off Mark

Most market participants believe that inflation is moderating and that the Federal Reserve will soon start cutting rates, perhaps as early as the first quarter of next year. It is not clear that this will be the case. Dallas Fed President Richard Fisher’s September speech confirmed the inflationary concerns echoed by the Federal Reserve Bank of San Francisco Janet Yellin, whose comments also were ignored by market participants. At that time, Yellin announced that while she voted to keep interest rates steady, she was prepared to tighten further if inflationary pressures intensified. The most revealing part of Fisher’s speech was his view that the Dallas Fed (and the Cleveland Fed) have begun to look at a new measure of inflation called the Trimmed Mean PCE Inflation Rate, which challenges the old way the Fed calculates inflation. When I first heard this term, I googled it and found a working paper written by a Dallas Fed researcher, James Dolmas. (A special thanks goes to John Mauldin for aggregating this study and the speeches of the Fed heads.) Dolmas explains that because food and energy have real meaning in a real world, he includes those factors and arrives at a more meaningful inflation gauge called a trimmed mean, by taking out outlier reports (discarding a certain amount of the lowest and highest values and then computing the mean of those that remain). Of course, the question is what does the Dallas Fed’s new measure of inflation indicate? The answer is a huge difference! According to Fisher, the trimmed core PCE inflation rate was 3.2% in July (compared to the 1.7% rate that the Fed uses for core PCE). This, of course, is well above the Fed’s comfort zone.

What Does the Future Hold for Inflation?

While the equity market focuses on the salutary effect of lower energy prices, grains are soaring and, importantly, the rate of growth in unit labor costs continues to accelerate to levels not seen in years. So are the nonenergy industrial materials index, tuition payments, insurance premiums and a host of other expenses rising, which will serve to keep real median incomes from advancing? (That’s a vulnerable situation given the absence of personal savings.) If the short term contains inflationary risks that are being ignored by most investors, the longer term seems even more problematic. Consider Federal Reserve Chairman Ben Bernanke’s recent speech regarding the threats of the coming crisis in Social Security and Medicare funding and Congress’ disregard for this issue. To summarize, he stated that if demographic issues surrounding Social Security and Medicare are not addressed, our population will have 14% less potential for consumption within the next 25 years. So far, Bernanke’s longer-term public-policy concerns have fallen on deaf ears in Congress, and the remarks made by three other Fed governors regarding inflationary pressures have fallen on deaf ears in the investment community.

The Prospect for Lower Profit Margins

Since 1950, there have been eight incidents of profit margin peaks: the third quarter of 1997; the fourth quarter of 1988; the first quarter of 1984; the fourth quarter of 1978; the fourth quarter of 1965; the fourth quarter of 1955; the first quarter of 1953 and the fourth quarter of 1950. Today’s profit margins (as measured by pretax profit relative to nominal GDP) stand at about 13% — that’s at the highest level since 1953! (Over the last half-decade, on average, margins peak at around 10.9% before contracting to 6.6% during economic slowdowns one year later.) In contrast to the current level of 13% margins, pretax corporate profit margins peaked at 7.4%, 7.8% and 9.8% in the three previous economic cycles. According to Merrill Lynch, in six of those eight occurrences of GDP slowdowns and peaking margins, corporate profits declined. On average, earnings growth went from +29% to -8% in the next year! So if history is a precedent — and given that so many signs suggest that top-line sales growth will be moderating and inflationary pressures stubbornly high — the bottoms-up forecast for 12%-13% earnings growth in 2007 appears to be a pipe dream.

A Dose of Reality

The tailwind of a world fueled by excessive stimuli is being replaced by these headwinds (and others), bolstering my outlook of a lumpy and uneven period of economic growth. For now, to paraphrase The Mamas and The Papas’ song Creeque Alley, everyone’s getting fat except Papa Kass. But, as night follows day, today’s chorus of booyahs will be replaced by a dose of reality in the months to come.

More later!

Mark