Doug Kass, "There are significant positive developments amid the tumult that are currently being ignored"

By on February 22, 2009

Doug Kass has written a very entertaining and enlightening article at thestreet.com. Mr. Kass compares and contrasts our current state of affairs to that experienced by the late Hunter Thompson in his well-known Fear and Loathing in Las Vegas. By the way, Kass was pointing out many bearish indications over a year ago, so he is definitely worth listening to.

Despite what Doug Kass sees as a lengthy and painful credit contraction, there are, in his opinion, values and reasons for bullishness being exposed in this debacle. He points out that many formerly optimistic commentators have accepted that things are not so good including Peggy Noonan at the Wall Street Journal. When you have perpetual optimists turning bearish you can argue that perhaps equity prices are reflecting most of the bad news coming. When you have the bears (and realists) like Nouriel Roubini extolled in the popular media, it could be that asset prices are approaching a bottom.

Mr. Kass states that some stocks have been bucking the downward trend indicating there is some tentative hope that fundamentals may improve, at least for things non-financial. Transocean (RIG), Freeport-McMoRan Copper & Gold (FCX) and MedcoHealth Solutions (MHS) are a few in this category.

Below is Kass’s checklist for a more favorable stock market environment to develop:

  • Bank balance sheets must be recapitalized. We await a bank rescue package in the week ahead.
  • Bank lending must be restored. Bank lending standards remain tight. For now, we are in a liquidity trap.
  • Financial stocks’ performance must improve. We are not yet there. Financials’ performance is still drek.
  • Commodity prices must rise as confirmation of worldwide economic growth. There has been some recent evidence of higher commodities, but it’s still inconclusive.
  • Credit spreads and credit availability must improve. While credit spreads are improving, the yield curve is rising and interest rates have rebounded, the transmission of credit remains poor. Time will tell whether monetary and fiscal policies will serve to unclog credit.
  • We need evidence of a bottom in the economy, housing markets and housing prices. The economy’s downturn continues apace. Months of inventory of unsold homes are declining and so are mortgage rates, but home prices have yet to stabilize despite an improvement in affordability indices.
  • We also need evidence of more favorable reactions to disappointing earnings and weak guidance. We are not yet there, but this will tell us a lot about the state of the stock market’s discounting process.
  • Emerging markets must improve. China’s economy (PMI and retail sales) and the performance of its year-to-date stock market have turned decidedly more constructive.
  • Market volatility must decline. The world’s stock markets remain more volatile than a Mexican jumping bean.
  • Hedge fund and mutual fund redemptions must ease. While Kass is comfortable in writing that most of the forced redemptions have likely passed, he feels we will find out more over the next few months. Regardless, the disintermediation and disarray of hedge funds and fund of funds have a ways to go.
  • A marginal buyer must emerge. Pension funds seem to be the likely marginal buyer as they reallocate out of fixed income into equities, but we have not yet seen the emergence of this trend.

Mr. Kass also highlights some statistical evidence that indicates that equities may have fallen enough to make them attractive including:

  1. The risk premium, the market’s earnings yield less the risk-free rate of return, is substantially above the long-term average reading.
  2. Using reasonably conservative assumptions (most importantly, a near 50% peak-to-trough earnings decline, which is over 3x the drop in an average recession), the market has discounted 2009 S&P 500 earnings of about $47.
  3. Valuations are low vis-à-vis a decelerating (and near zero) rate of inflation. Indeed, the current market multiple is consistent with a 6% rate of inflation.
  4. Stock prices as a percentage of replacement book value stand at 1x, well below the 1.4x long-term average.
  5. The market capitalization of U.S. stocks vs. stated GDP has dropped dramatically, to about 80%, now at the long-term average. Warren Buffett was recently interviewed in Fortune Magazine and observed that this ratio was evidence that stocks have become attractive.
  6. The 10-year rolling annualized return of the S&P is at its lowest level in nearly 75 years, having recently broken below the levels achieved in the late 1930s and mid 1970s.
  7. A record percentage of companies have dividend yields that are greater than the yield on the 10-year U.S. note. At 46% of the companies, that is over 4x higher than in 2002 and compares against only 5% on average over the last 30 years.

There is much more at:

http://www.thestreet.com/story/10464211/1/kass-fear-and-loathing-on-wall-street.html

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