Doug Kass’s Surprises

Seabreeze partner Doug Kass was kind enough to send us his 20 surprise predictions for 2009. As Doug explains, these predictions are outliers, not events that have a high likelihood of occuring (if they did, they wouldn’t be surprises).

In late December over the past six years, I have taken a page from former Morgan Stanley strategist Byron Wien (now the chief investment strategist at Pequot Capital Management) and prepared a list of possible surprises for the coming year.

These are not intended to be predictions but rather events that have a reasonable chance of occurring despite the general perception that the odds are very long. I call these "possible improbable" events…

1. The Russian mafia and Russian oligarchs are found to be large investors with Madoff. During the next few weeks, a well-known CNBC investigative reporter documents that the Russian oligarchs, certain members of the Russian mafia and several Colombian drug cartel families have invested and laundered more than $2 billion in Madoff’s strategy through offshore master feeders and through several fund of funds. There are several unsuccessful attempts made on Madoff and/or his family’s lives. With the large Russian investments in Madoff having gone sour and in light of the subsequent acts of violence against his family, U.S./Russian relations, which already were at a low point, are threatened. Madoff’s lawyers disclose that he has cancer, and his trial is delayed indefinitely as he undergoes chemotherapy.
2. Housing stabilizes sooner than expected. President Obama, under the aegis of Larry Summers, initiates a massive and unprecedented Marshall Plan to turn the housing market around. His plan includes several unconventional measures: Among other items is a $25,000 tax credit on all home purchases as well as a large tax credit and other subsidies to the financial intermediaries that provide the mortgage loans and commitments. This, combined with a lowering in mortgage rates (and a boom in refinancing), the bankruptcy/financial restructuring of three public homebuilders (which serves to lessen new home supply) and a flip-flop in the benefits of ownership vs. the merits of renting trigger a second-quarter 2009 improvement in national housing activity, but the rebound is uneven.  While the middle market rebounds, the high-end coastal housing markets remain moribund, impacted adversely by the Wall Street layoffs and the carnage in the hedge fund industry. 
3. The nation’s commercial real estate markets experience only a shallow pricing downturn in the first half of 2009. President Obama’s broad-ranging housing legislation incorporates tax credits and other unconventional remedies directed toward nonresidential lending and borrowing. Banks become more active in office lending (as they do in residential real estate lending), and the commercial mortgage-backed securities market never experiences anything like the weakness exhibited in the 2007 to 2008 market. Office REIT shares, similar to housing-related equities, rebound dramatically, with several doubling in the new year’s first six months.
4. The U.S. economy stabilizes sooner than expected. After a decidedly weak January-to-February period (and a negative first-quarter 2009 GDP reading, which is similar to fourth-quarter 2008’s black hole), the massive and creative stimulus instituted by the newly elected President begins to work. Banks begin to lend more aggressively, and lower interest rates coupled with aggressive policy serve to contribute to an unexpected refinancing boom. By March, personal consumption expenditures begin to rebound slowly from an abysmal holiday and post-holiday season as energy prices remain subdued, and a shallow recovery occurs far sooner than many expect. Second-quarter corporate profits growth comfortably beats the downbeat and consensus forecasts as inflation remains tame, commodity prices are subdued, productivity rebounds and labor costs are well under control.
5. The U.S. stock market rises by close to 20% in the year’s first half. Housing-related stocks (title insurance, home remodeling, mortgage servicers and REITs) exhibit outsized and market-leading gains during the January-to-June interval. Heavily shorted retail and financial stocks also advance smartly. The year’s first-half market rise of about 20% is surprisingly orderly throughout the six-month period, as volatility moves back down to pre-2008 levels, but rising domestic interest rates, still weak European economies and a halt to China’s economic growth limit the stock market’s progress in the back half of the year.
6. A second quarter "growth scare" bursts the bubble in the government bond market. The yield on the 10-year U.S. Treasury note moves steadily higher from 2.10% at year-end to over 3.50% by early fall, putting a ceiling on the first-half recovery in the U.S. stock market, which is range-bound for the remainder of the year, settling up by approximately 20% for the 12-month period ending Dec. 31, 2009. Foreign central banks, faced with worsening domestic economies, begin to shy away from U.S. Treasury auctions and continue to diversify their reserve assets. By year-end, the U.S. dollar represents less than 60% of worldwide reserve assets, down from 2008’s year-end at 62% and down from 70% only five years ago. China’s 2008 economic growth proves to be greatly exaggerated as unemployment surprisingly rises in early 2009 and the rate of growth in China’s real GDP moves towards zero by the second quarter. Unlike more developed countries, the absence of a social safety net turns China’s fiscal economic policy inward and aggressively so. Importantly, China not only is no longer a natural buyer of U.S. Treasuries but it is forced to dip into it’s piggy bank of foreign reserves, adding significant upside pressure to U.S. note and bond yields.
7. Commodities markets remain subdued. Despite an improving domestic economy, a further erosion in the Western European and Chinese economies weighs on the world’s commodities markets. Gold never reaches $1,000 an ounce and trades at $500 an ounce at some point during the year. (Gold-related shares are among 2009’s worst stock market performers.) The price of crude oil briefly rallies early in the year after a step up in the violence in the Middle East but trades in a broad $25 to $65 range for all of 2009 as President Obama successfully introduces aggressive and meaningful legislation aimed at reducing our reliance on imported oil. The price of gasoline briefly breaches $1.00 a gallon sometime in the year. The U.S. dollar outperforms most of the world’s currencies as the U.S. regains its place as an economic and political powerhouse.
8. Capital spending disappoints further. Despite an improving economy, large-scale capital spending projects continue to be delayed in favor of maintenance spending. Technology shares continue to lag badly and Advanced Micro Devices (AMD) files bankruptcy.
9. The hedge fund and fund of funds industries do not recover in 2009. The Madoff fraud, poor hedge fund performance and renewed controversy regarding private equity marks (particularly among a number of high-profile colleges like Harvard and Yale) prove to be a short-term death knell to the alternative investments industry. As well, the gating of redemption requests disaffects high net worth, pension plan, endowment and University investors to both traditional hedge funds and to private equity (which suffers from a series of questionable and subjective marking of private equity deal pricings at several leading funds). Three of the 10 largest hedge funds close their doors as numerous hedge funds reduce their fee structures in order to retain investors. Faced with an increasingly uncertain investor base, several big hedge funds merge with like-sized competitors in a quickening hedge fund industry consolidation. By year-end, the number of hedge funds is down by well over 50%.
10. Mutual fund redemptions from 2008 reverse into inflows in 2009. The mutual fund industry does not suffer the same fate as the hedge fund industry. In fact, a renaissance of interest in mutual funds (especially of a passive/indexed kind) develops.  Fidelity is the largest employer of the graduating classes (May 2009) at the Wharton and Harvard Business Schools; it goes public in late 2009 in the year’s largest IPO. Shares of T. Rowe Price (TROW) and AllianceBernstein (AB) enjoy sharp price gains in the new year. Bill Miller retires from active fund management at Legg Mason (LM). 
11. State and municipal imbalances and deficits mushroom. The municipal bond market seizes up in the face of poor fiscal management, revenue shortfalls and rising budgets at state and local levels. Municipal bond yields spike higher. A new Municipal TARP totaling $2 trillion is introduced in the year’s second half.
12. The automakers and the UAW come to an agreement over wages. Under the pressure of late first-quarter bankruptcies, the UAW agrees to bring compensation in line with non-U.S. competitors and exchanges a reduction in retiree health care benefits for equity in the major automobile manufacturers.
13. The new administration replaces SEC Commissioner Cox. Upon his inauguration, President Obama immediately replaces SEC Commissioner Christopher Cox with Yale Professor Dr. Jeffrey Sonnenfeld. The new SEC commissioner recommends that the uptick rule be reinstated and undertakes a yearlong investigation/analysis into the impact of Ultra Bear ETFs on the market. Later in the year, the administration recommends that the SEC be abolished and folded into the Treasury Department. Dr. Sonnenfeld returns to Yale University.
14. Large merger of equals deals multiply. Economies of scale and mergers of equals become the M&A mantras in 2009, and niche investment banking boutiques such as Evercore (EVR), Lazard (LAZ) and Greenhill (GHL) flourish. Goldman Sachs and Citigroup announce a merger of equals, but Goldman maintains management control of the combined entity. Morgan Stanley (MS) acquires Blackstone. Disney (DIS) purchases Carnival (CCL). Microsoft (MSFT) acquires Yahoo! (YHOO) at $5 a share.
15. Focus shifts for several media darlings. Though continuing on CNBC, Jim "El Capitan" Cramer announces his own reality show that will air on NBC in the fall. At the time his reality show premieres, he also writes a new book, Stay Mad for Life: How to Prosper from a Buy/Hold Investment Strategy. Dr. Nouriel Roubini continues to talk depression, but the price of his speaking engagements are cut in half. He writes a new book, The New Depression: How Leverage’s Long Tail Will Result In Bread Lines. "Kudlow & Company’s" Larry Kudlow proclaims that it’s time to harvest the "mustard seeds" of growth and, in an admission of the Democrat’s growing economic successes, officially leaves the ranks of the Republican party and returns to his Democratic roots. Yale’s Dr. Robert Shiller adopts a variant and positive view on housing and the economy, joining the bullish ranks and writes a new book, The New Financial Order: Economic Opportunity in the 21st Century.
16. The Internet becomes the tactical nuke of the digital age. The Web is invaded on many levels as governments, consumers and investors freak out. First, an act of cyberterrorism occurs that compromises the security of a major government (similar to the attacks this year emanating from the Chinese military aimed at the German Chancellery) or uses DoS against media and e-commerce sites. Second, a major data center will fail and will be far worse than the 1988 Cornell student incident that infected about 5% of the Unix boxes on the early Internet. Third, cybercrime explodes exponentially in 2008. Financial markets will be exposed to hackers using elaborate fraud schemes (such as liquidating and sweeping online brokerage accounts and shorting stocks, then employing a denial-of-service attack against the company). Fourth, Storm Trojan reappears. (Same as last year.)
17. A handful of sports franchises file bankruptcy. Three Major League Baseball teams fail in the middle of the season and seek government bailouts in order to complete the season. The Wilpon family, victimized by Madoff, sells the New York Mets to SAC’s Steve Cohen. The New York Yankees are undefeated in the 2009 season, and Madonna and A-Rod have a child together (out of wedlock).
18. The Fox Business Network closes. Racked by large losses, Rupert Murdoch abandons the Fox Business Network. CNBC rehires several prior employees and expands its programming into complete weekend coverage. Two popular CNBC commentators "go mainstream" and become regulars on NBC news programs.
19. Old, leveraged media implode. The worlds of leverage and old media collide in a massive flameout of previous leveraged deals. Univision and Clear Channel go bankrupt. The New York Times (NYT) teeters financially.
20. The Middle East’s infrastructure build-out is abruptly halted owing to "market conditions." Lower oil prices, weakening European economies and a broad overexpansion wreck havoc with the Middle East’s markets and economies.