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Sustained Market Advance Unlikely
Commentary by Doug Kass, who writes daily for RealMoney Silver, a premium bundle service from For a free trial and exclusive access to Mr. Kass' daily trading diary, please click here RealMoney Silver.

Over the course of the last six to 12 months, I have had an ongoing dialogue with three individuals who know a lot more than me about the economy and the stock markets. All three, at one time or another, were the top-ranked strategists on Wall Street. To be honest, their collective grasp of the economy and the markets well exceeds almost any market observer extant.

I think they enjoy our dialogues and converse frequently with me, mainly because I provide a reasonably thoughtful and devil's advocate view. And I certainly respect their views and even their guidance, at times.

All three have been bullish over the course of the last two years, though one has recently become a convert to the dark side.

In essence, their collective view is that the domestic economic recession will be mild by historic standards:

  • The Treasury plan will remedy and ultimately reverse the credit crisis.
  • A second fiscal package is being framed and will provide a catalyst to growth.
  • The Fed will continue to be a friend of the markets.
  • A moratorium on home foreclosures will kick-start housing.
  • Today's share prices discount a more-severe-than-average recession.
From here, the path of least resistance that they surmise for the stock market is up as a several-year period of below trendline economic growth will still produce modest profits but tamer inflation. When the credit crisis ends, they surmise, the world's economy will be more balanced, setting the stage for total returns from common stocks on the order of up 6% to 7%; although lower than historic returns of up 9% to 10%, these are compelling returns nonetheless relative to historically low interest rates and modest inflation.

While I believe that the market has likely hit its lows for the, the purpose of this column is to counter the economic argument of my esteemed friends, which I (naturally) believe to be currently more persuasive.

  1. A sustained market advance appears unlikely.

  2. The next several years will provide substantially subpar investment returns.
Jolts and dislocations are the order of the day.

From my perch, the primary issue is not whether the current economic recession will be more severe than the average recession; it's whether the weakness in economic activity will linger well beyond 2009 and if the possibility exists that the recession in corporate profits will be deeper than consensus in 2009 to 2010. After all, if the weakness in profits does continue through 2011 to 2012, it will render the Street's expectations for S&P 500 profits over the next three years as way to high, providing a formidable headwind against equities.

The only positive I see concerns the magnitude of the equity devastation; I suppose it's not likely to get much worse. Whether the equity markets have discounted the weak economic setting (and still high but reduced expectations), which could be with us for much longer than most expect, remains the issue, and I don't pretend to have the answer. But I have a hunch.

Unquestionably, I see continuing economic headwinds and limited economic clarity.

1. Housing will remain in the toilet. Despite the deceleration in the rate of the decline in home prices, the consumer faces a moribund housing market for some time to come. Unsold home inventories are near record levels and will take time to absorb, and despite repeated policy attempts, mortgage credit remains unavailable to most prospective homeowners.

My longtime contention that a housing recovery will not occur until 2010 at the earliest was certainly confirmed by a conversation I had on Monday with a housing executive, who remarked that housing demand/traffic has never (in history) been weaker than in the last two months. His words used to describe the state of the housing market were "frozen" and "total destruction."

2. The nonresidential real estate markets are now just turning south. I had three downbeat conversations with the CEOs of large commercial REITs over the course of the last five days. There are virtually no investment sales, larger rental programs (over 200,000 square feet) have almost all been put on hold, and the retail/shopping center businesses began to deteriorate in late August -- and the decline is now accelerating. The New York City market, a lagging indicator, has even begun to show signs of weakening activity. And all three CEOs agreed that, with the cost cutting in financial intermediaries (banks, hedge funds), the picture will not get better for years.

3. The consumer remains cooked. The consumer faces a huge debt load, poor job creation and a real jolt in disappearing stock portfolios. The only positive over the horizon is a decelerating rate of inflation, which will have a salutary impact on real incomes. Nonetheless, under these circumstances, consumer confidence has been obliterated and will take time to come back. For further evidence of the consumer's wobbly state, just look at PepsiCo's stock yesterday, down $7 after it's "chilling" quarterly report.

4. Given that a series of hastily crafted policy (fiscal and other) decisions have failed to have any effect, why should the latest investment in banks revive lending? And even if it does, it will only do so over time. Banks, like the American consumer, have been jolted, suffering a massive heart attack. You don't just jump out of bed and play three sets of tennis or a round of golf after cardiac arrest. An article from Bloomberg this morning raises this same argument.

5. President Obama. Politics of trade protectionism and higher corporate and individual taxes are the order of the day beginning in January 2009. The consumer, under a Democratic administration, will likely gain a bigger piece of the pie than corporations did in the Republican administration. And, with profit margins at 53-year highs, profitability is ever more vulnerable.

6. If the first fiscal stimulus package failed to revive growth, with conditions now much worse than in the spring of last year, why should a second have an enduring impact? The answer to me is that it may, or it may not.

7. The dislocations caused by the turmoil in the hedge fund and fund of fund industries, concentrated and margined CEO holdings now increasingly being routinely sold out in margin calls and growing individual investor disenchantment with the depressing performance of stocks lead many to ask who is the marginal buyer to sustain a market recovery. Again, similar to the heart attack analogy, time is needed to return back to health -- or, in the case of stocks, to lead toward a propensity to reinvest.

The people to whom I speak - namely, investors who are friends and relatives and who don't work on Wall Street -- just about the last thing they care to engage in is stock investing now. Not surprisingly, they are more concerned with their job security and other issues.

So where is the marginal buyer of stocks to sustain a market recovery? Allocations by fund of funds are virtually nonexistent and probably won't improve in 2009. Do you really think that the healthy large hedge funds like SAC and the others, which recently raised cash, are going to turn around and quickly commit? Do you really think, with the uncertainty of redemptions and the volatility of the markets, that the largest hedge-hoggers will get off their hands and buy on strength?

In summary, the market (and economic) headwinds are strong, and Toto is lost. Somewhere there will be a rainbow, but the message of the markets in 2008 is that we aren't in Kansas anymore.

Doug Kass writes daily for RealMoney Silver, a premium bundle service from For a free trial to RealMoney Silver and exclusive access to Mr. Kass' daily trading diary, please click here.

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