Submitted by Mark Hanna
Courtesy of MarketMontage. View original post here.
While you can always agree or disagree with any particular pundit, it is worthwhile to examine the views of those who actually construct a decent group of parameters for their thoughts. That said, the market can make all logic seem foolish for a time, even that which is ultimately correct. Hedge fund manager Doug Kass, who was quite bullish at year end 2011 with an excellent call on 2012 being the year of financials, has recently turned much more cautious. Today he has a piece out saying flatly the market is now overvalued. While one might dismiss it as ‘chicken little’, recall that 3 months ago almost no one wanted to buy the market citing a litany of (valid) reasons at today everyone wants in the market – at any prices. Reasons to be out, be damned. 
The whole piece is worthwhile (free at TheStreet.com) but I wanted to pick out a specific section and give my point, counterpoint to it. My comments will be in blue.
Secular Issues and Deflating Cap Valuations
Below are some of the other secular factors that investors should be concerned with over the near term that will likely cap the market’s upside.
- Monetary: I see a U.S. monetary cliff at the end of June coincident with the completion of the Fed’s quantitative-easing program.
This assumes no new QE program in summer, once Operation Twist ends. The market has changed its view quite sharply on more easing over the past week or so, but I still am in the camp it will come. Too many doves on the board, and most importantly King Dove sings at the head of the table. But more seriously, the Fed will see the stopping of monetary easing as tightening – so at minimum they will want to replace Operation Twist with something. Their world view will not have changed that dramatically in 6-10 weeks from now, and I expect some economic data to begin to slow as (a) expectations for data have risen so “beating expectations” will become harder and (b) favorable seasonal effects will dissipate.
If Kass is correct it will be an obvious body blow to the market which is addicted to monetary stimulus. Also of course oil is a wildcard, but Bernanke has stated he does not believe monetary easing inflates asset prices such as commodities – only by magic asset prices such as stock. (i.e. money know exactly where to go)
- Fiscal: I see a U.S. fiscal cliff at year-end 2012, with the $500 billion fiscal drag of rising tax rates and government spending cuts.
As I said in my interview with Andrew Horowitz I simply do not see a Congress willing to bite the bullet on anything. These folks, like politicians all over the world, love to kick the can. You will have a lame duck Congress post election facing Bush tax cuts and I simply cannot see them doing anything but extending them – after a TON of hot air blasted into the air. As for those defense cuts and sequestration et al, I would put that as a 80% chance of not happening. Or if it happens it will be expensed out over a decade i.e. we will cut $1 in 2013, $2 in 2014, $3 in 2015 and ummm $498 Billion in 2023. The normal accounting tricks will also be used. I also expect the payroll tax cut to be extended YET again, after again – a lot of hot air. Politicians simply do not make any difficult decisions and once something is given away they almost never take it back.
If Kass is correct, it will be a big body blow as 10% annual deficits are now the order of the day and putting a huge floor under the economy. Even a return to 6% deficits not to mention something like 3% will feel like a shock to the system. Please note (as an aside) spending “cuts” are the wrong term. There is almost never an absolute cut in U.S. federal spending, it is a cut in the RATE of future spending; I wish the press would label this correctly.
- Deficit: Our fiscal imbalances have yet to be addressed. Every day that goes by raises the size of our fiscal challenge, as does every basis point that bond rates climb.
The market will not care about something like this until one day it does. That could be in 3 months or 30 years. I would not list it as a near term worry. The only worry is a debt ceiling debate which is a self imposed punishment – there is no limitation to the amount of debt a sovereign currency can create. Of course at some point it creates inflation and others in the world can choose to not accept said currency but as the reserve currency the U.S. has benefits no other country does. Japan is at a far greater deficit to GDP and has not felt any punishment despite calls for 2 decades for their demise. We’re ahead of Japan in that pecking order.
- Unemployment: Despite the recent improvement in the jobs market, a number of factors will conspire to keep the unemployment rate elevated. Those factors include technological innovation, globalization, a mismatch between job needs and talent/skills/education and a large drop in U.S. home prices (which reduces geographical mobility, as many homes are underwater).
Agreed and has been a thesis of mine for years. The U.S. has a permanent underclass of former middle class whose jobs have been globalized away. Many jobs we are celebrating now pay less than those that they replaced. That said any sort of boom in construction will mitigate these issues – but the U.S. remains mostly overbuilt in many areas.
- Valuation History: The history of markets during periods of relatively modest changes in corporate profits (I estimate a range between +3% and +5% for both 2012 and 2013), subpar economic growth (less than 2%) and rising inflation make for a flat, not an expanding, P/E multiple. Revenue and profits forecasts are coming down, conspicuously so, if one excludes the exceptional results and very upbeat forecasts for Apple (AAPL_). I continue to see a growing probability that corporate profit margins are in jeopardy, as unit labor costs rise and as core PPI is running ahead of core CPI.
Agreed. Last quarter was relatively poor for earnings growth – it was essentially Apple and AIG which created 90% of S&P 500 earnings growth. Many other companies beat earnings estimates that were lowered during the worries of November and December 2011. But all of it was overlooked under the guise of massive monetary easing from Europe and a rebound to mean in economic data, especially in the U.S. April should be far more tricky on that front. Also as Kass noted, and we’ve written a few times – profit margins are weakening.
- Political: The outcome of the U.S. and French elections introduces market uncertainty and could adversely limit addressing fiscal issues and reverse recent strides in containing the debt crisis in Europe.
There could be some uneasy period in the summer due to politics but I think more of it will come over uncertainty of tax policy and the spending cuts mentioned above. But whatever combination of President and Congress comes out of November, I expect a lot of punting as stated above. Short of a Ron Paul presidency with 200 new Tea Partiers in Congress, the rest are all pretty much the same, regardless of the party label attached to their name.
- Black Swans: We have witnessed a greater frequency of black swans (economic, political, geopolitical and physical disasters) over the past two decades. I have speculated that the price of oil might be the next black swan.
Oil is the one obvious black swan, but if it is obvious is it a black swan? Of course we could have a flash crash, an attack on Iran (but I doubt that happens – if ever – until U.S. elections are over), or physical disaster. But after the initial reaction to said Black Swan, the chorus of MORE QE would rain from the speculator class and we can bet our friendly central bank would oblige immediately.
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Any securities mentioned on this page are not held by the author in his personal portfolio. Securities mentioned may or may not be held by the author in the mutual fund he manages, the Paladin Long Short Fund (PALFX). For a list of the aforementioned fund’s holdings at the end of the prior quarter, visit the Paladin Funds website at http://www.paladinfunds.com/holdings/blog
