This commentary originally appeared at 8:50 a.m. EST on Feb. 13 on Real Money Pro — for access to all of legendary hedge fund manager Doug Kass’s strategies and commentaries, click here.
So far, the Cassandras’ predictions of global collapse and failure have been proven false. Some of the most notorious bears are now turning bullish and revising their forecasts to the positive. Other « gloom and doom » holdouts are feeling the heat. We think that heat will intensify…. Why have all the Cassandras been wrong? Because they ignored the power of central banks to cause credit spreads to narrow. The outcome is reflected in market movements and in certain sectors….
The European Central Bank’s ingenious concept of a three-year, 1% loan via LTRO (long-term refinancing operation) worked. It was successful because it allowed the banks to buy their own debt at a higher yield than 1%, book the difference in yield as income, and mark up the value of their own bonds to par. That process functioned as a mechanical way for there to be an addition to the bank’s capital. The ECB used a creative way to solve a portion of its eurozone and the Europe-wide banking crisis….
We have replaced meltdown of the type we saw after Lehman/AIG with « melt-up » of the type we have been seeing since March 2009. We have shifted from collapsing leverage and failure at the institutional level to central bank intervention of unprecedented size….
We are going through huge transitional times. Never before have we seen coordinated, global central bank activity of this order or magnitude. By the end of this year, the G4 central banks will have expanded their balance sheets approximately threefold during the financial crisis. The negative and inflationary results of this activity may appear in the future. That remains to be seen. For the present, this is a very bullish construction for asset prices and equities in particular.
— David Kotok, Cumberland Advisors (Feb. 11, 2012)
I continue to have an optimistic outlook on the intermediate-term market, and I expect the S&P 500 to range in price between 1250 and 1550 for the full year. (That’s 2:1 upside vs. downside.)
That said, over the short term, the S&P 500 now appears fairly priced after January’s rise, and I expect the index to range in price between 1250 and 1400 over the next few months. (That’s 2:1 downside vs. upside.)
Anecdotally (and not surprisingly), investor sentiment, which was so dismal at the start of 2012, has now begun to reverse quickly. Sideline cash has worked itself into the markets, as evidenced by the consistent rally in the first six weeks of the year, and, in turn, the business media are now populated by a chorus of talking heads that are singing « Everything Is Coming Up Roses. »
Most investor surveys indicate a substantial rise in bulls and decline in bears over the past few weeks: Investors Intelligence bulls (52%), the National Association of Active Investment Managers bulls (73%) and Consensus Inc. (stock traders) bulls (72%) are at the highest levels in 12 months, 10 months and 13 months, respectively. The CBOE 10-day put/call ratio is down to 0.84, or at the lowest reading since April 2011. Barron’s’ cover this past weekend contained the headline « Dow Jones 15,000, » and even doomsayer Dr. Nouriel Roubini is now a market optimist.
Chasing stocks (in either direction) is not my modus operandi, as my investment mantra is that price is what you pay but value is what you get.
Even in a fairly priced market, however, in which reward and risk are generally in balance, one can still select long positions that can outperform the indices and shorts that will underperform the indices. Importantly, I am hopeful that, in a still volatile market, I can add alpha to my long and short investment positions by trading opportunistically (the cash register effect).
For now, a 30% to 40% net long exposure for a hedge fund and a 50% exposure for a long-only investor fund seems appropriate.
Assuming my baseline economic and profit expectations remain intact, my preferred batting style is to wait for the right pitch now, and I would expect to be raising my long exposure during any short term market price weakness.
« He who lives by the crystal ball soon learns to eat ground glass. »– Edgar R. Fiedler, « The Three R’s of Economic Forecasting — Irrational, Irrelevant and Irreverent »
My starting point when I construct my portfolio and determine exposures is always valuation.
I fully recognize that modeling an S&P 500 price target implies a degree of precision in an imprecise world. More often than not, markets overshoot, both to the upside and downside. Nevertheless, while our exercise and process are not intended to be an exact science, this sort of methodology eliminates emotion and has historically added value as an investment discipline.
Updated Fair Market Value Calculation for the S&P 500
Below is an updated view of the criteria I use to evaluate the S&P 500 and for which I conclude that fair market value is approximately 1345 (almost exactly the price level of Friday’s close).
Scenario No. 1 (probability 25%): The pace of U.S. economic recovery reaccelerates to slightly above-consensus forecasts (3%-plus real GDP) based on pro-growth fiscal policies geared toward generating job growth; corporate profit margins being preserved (with low inflation and contained wage growth); interest rates remaining low; and housing recovering sharply, owing to the adoption of aggressive plans by the government to enact a massive home refinancing effort and deplete the excess inventory of unsold homes. Europe stabilizes (and experiences only a shallow recession), and China has a soft landing. S&P 500 profit estimates for 2012 are raised modestly to $106 to $110 per share. Stocks, valued at 14.5x under this outcome, have 16% upside over the next 12 months. S&P target is 1,565.
Scenario No. 2 (probability 5%): The U.S. enters a recession precipitated by a loss of business and consumer confidence, producing a fall in manufacturing output and personal consumption expenditures. A series of bank failures and sovereign debt defaults in the eurozone contribute to a deep European recession and a hard landing in China and India. S&P 500 earnings estimates for 2012 are materially slashed to $75 to $80 per share. Stocks, valued at 10.0x under this outcome, have 42% downside risk over the next 12 months. S&P target is 775.
Scenario No. 3 (probability 25%): The U.S. experiences a disappointing sub-1% real GDP growth rate, and Europe experiences a medium-scale recession. S&P 500 profit forecasts for 2012 are cut back to $98 to $100 a share (only slightly above 2011’s levels). Stocks, valued at 12x under this outcome, have 12% downside risk over the next 12 months. S&P target is 1185.
Scenario No. 4 (probability 45%): The U.S. muddles through with 1.5%-2.0% real GDP growth, and the European economies suffer a modest (but contained) business downturn. S&P 500 profits for 2012 trend toward a range of $103-$105 a share as some margin slippage occurs. Stocks, valued at 13.25x under this outcome, have 2% upside over the next 12 months. S&P 500 target is 1,375.
To conclude, the S&P 500 closed at 1342 on Friday, almost exactly the level (1345) that I calculate as fair market value based on the four economic and stock market outcomes (and probabilities) listed above. Risk and reward, therefore, seems generally in balance.
The Ingredients for a New High in the S&P 500 in 2012
Let’s now shift our narrative from the near term to the intermediate term, for it is the intermediate term that excites me as an investor.
In order for the markets to approach all-time highs in 2012, which I continue to view as possible, much must go right.
My ambitious 1550 target for the S&P 500 (first offered in December 2011) seems less of an outlier today than two months ago. It would require the revival of animal spirits driving valuations back to average historical levels, which would be a difficult but not impossible feat given economic, geopolitical and political uncertainties and within the context of the headwinds of our country’s fiscal imbalances.
Below are 10 important factors that I am monitoring — with current trends in parentheses; four are moving positively, and six are moving negatively — that could catapult the market this year to much higher levels.
- An improving U.S. economy (+): Economic statistics (PMIs, ISMs, leading indicators, housing and jobs) must continue to be on the mend.
- A soft landing in India and China (-): Growth is moderating while inflation is accelerating.
- Broad-based technical strength (-): The market’s breadth has started to narrow (often a sign of a potential top), as a few high-profile stocks seem to be responsible for most of the recent advance Indeed, one might describe this as « the NBA market, » as in « nothing but apple. »
- Reduced volatility (-): Market volatility must continue to subside. It has trended lower throughout January but has recently started to rise.
- Political compromise in the U.S. (-): Our political leaders must become less divisive and less divided. Unfortunately, as we move closer to the November elections, compromise (leading to pro-growth fiscal initiatives) seems a more distant possibility.
- Global monetary ease (+): We remain comfortable that central bankers around the world will continue to keep interest rates low.
- Containment of the eurozone debt crisis (+): Europe’s central bankers and leaders must continue to implement policy that contains the debt contagion (as they have in recent months).
- Reduced geopolitical risk (-): If anything, the tension between Israel and Iran has intensified.
- Prospects for a Republican presidency (-): Politics aside, history shows and most investors today view a Republican victory as business- and market- friendly. However, recent Romney caucus and primary losses have improved the chances of the Democratic Party recapturing the presidency. (The Intrade.com probabilities have declined for Romney to win the nomination from almost 90% to under 80% and have been lifted for Obama to win the presidency from the low 50%s to nearly 60% now.)
- Improving fund flows (+): The multiyear trend in which individual investors and hedge funds retreat from U.S. equities must be reversed. Retail investors have begun to commit money into domestic equity funds over the last three weeks and ISI’s hedge fund survey indicated a sharp increase in net long exposure last week.
What to Own?
Despite my optimism, I maintain it is important to be well diversified.
My long book consists of companies that have dominant franchises (and protective moats), relatively strong secular growth prospects, trade at reasonable valuations and are generally expected to exceed near-term consensus profit forecasts. I continue to believe that quality companies are on sale. Examples include Colgate-Palmolive (CL), Clorox (CLX), Dell (DELL), Disney (DIS), E*Trade (ETFC), Ford (F), Freeport-McMoRan Copper & Gold (FCX), General Motors (GM), International Flavors & Fragrances (IFF), Kellogg (K), KKR Financial (KFN), Lincoln National (LNC), MetLife (MET), MGIC Investment (MTG), Och-Ziff (OZM), PepsiCo (PEP), Procter & Gamble (PG), Prudential (PRU), Schwab (SCHW) and T. Rowe Price (TROW).
My short positions consist of companies that have challenged long-term business models and/or are expected to disappoint on the earnings front over the shorter term. I currently have limited short exposure, which includes American Express (AXP), Grand Canyon Education (LOPE), Henry Schein (HSIC), Morgan Stanley (MS) and Patterson Companies (PDCO) are my only individual short equity positions.
I remain short U.S. bonds and plan to expand this strategy if fixed-income yields drop further.