Kass: 10-Surprises Which Could Spike The Market 5% In One Day

Written by Doug Kass

“Look up and not down; look out and not in; look forward and not back, and lend a hand.” – Edward Everett Hale

Make no mistake about it, the stock market panic and Bear Market of November-December 2018 is serious and profoundly threatens the economic and profit pictures.

As mentioned on Friday, a fragile domestic economy may be undermined by the negative wealth effect of lower equity prices:

“The wealth effect is a theory suggesting that when the value of equity portfolios are on the rise because of accelerating stock prices, individuals feel more comfortable and confident about their wealth, which will cause them to spend more. In 1968, for instance, economists were mystified when a 10 percent tax hike failed to put the brakes on consumer spending. Later, the sustained spending was credited to the wealth effect. Even though disposable income declined because of the additional tax burden, wealth continued to grow because the stock market persistently climbed higher.”— Investopedia

According to Wilshire Associates, the U.S. stock market fell by $2.1 trillion last week. That loss in value is more than 10% of the 2017 U.S. Gross Domestic Production (GDP) of $19.3 trillion. (Our domestic GDP represents approximately 31% of world GDP). The loss in value from the September 2018 market top is well in excess of $5 trillion, representing about 25% of projected 2018 U.S. GDP.

The fixed income’s message of slowing economic and profit growth has been resounding — and until recently has been dismissed by most who were intoxicated by rising equity prices and favorable (but lagging) economic data.

Given the steady drumbeat of disappointing high-frequency economic data that suggest consensus growth expectations are too optimistic and underscores the fragile state of the domestic economy, this is a particularly untimely period for stocks to crater.

The economy — from a rate of change standpoint — is now at a critical point. No doubt a lot of damage to forward 2019 economic growth has already occurred and will result in a reduction in consensus profit forecasts. Any further damage to the stock market will amplify the heightened and powerful headwinds of the negative wealth effect — something few have considered.

All is Not Lost – Look Up and Not Down

To many who have taken a large hit to their investment portfolios over the last six weeks, all seems lost.

As bad as things feel this morning (the worst month of December since 1928), all is not lost.

Though rising recession risks are expanding and the U.S. growth outlook will be tested in 2019, history shows that it truly is darkest before the dawn.

That said, investor sentiment – based on many measures – has now been reduced to pure fear, an ingredient that didn’t exist during the lengthy Bull Market in Complacency so apparent over the last 2-3 years. Under the weight of near unprecedented financial market volatility many of the most confident optimists prior to October are now the most confident pessimists today. (Like the panicky ETF holder community – who too often emotionally redeem at or near the bottom – and the levered risk parity boyz, they too often buy high and sell low).

“I’m astounded by people who want to ‘know’ the universe when it’s hard enough to find your way around Chinatown.”- Woody Allen

My annual Surprise List is not about predictions. Rather, my Surprise List incorporates the notion of Possible Improbables. In sports, betting my surprises would be called an “overlay”, a term commonly used when the odds of a proposition are in favor of the bettor rather than the house.

The List is the outgrowth of five core lessons I have learned over the course of my investing career:

1. How wrong conventional wisdom can consistently be.
2. That uncertainty will persist.
3. To expect the unexpected.
4. That the occurrence of Black Swan events are growing in frequency.
5. With rapidly changing conditions, investors can’t change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.

With the S&P (cash today at 2350 and not 2930 – the September high), today’s Top Ten (surprises) take a different and more upbeat tone that my year end 15 Surprises for 2019.

Given my calculus that the S&P’s “fair market value” is approximately 2450, we should begin to look up and not down as the upside reward v. downside risk has finally shifted into positive ground.

Two quotes, one from an acquaintance (The Oracle of Omaha) and one from a friend (By) come to mind this morning:

“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.” – Warren Buffett

“Disasters have a way of not happening.” – Byron Wien

And we should be considering what positive Surprises may occur that could reverse the carnage of the last few months in our markets…

My Top Ten List

Here are the Top Ten possible events that could cause stocks to rise by at least 5% in one trading session:

1. An announcement by the Federal Reserve that it plans to transition from the rigid language of “gradual increases” to a more flexible economic data and market dependent policy. Investors immediately interpret this message to mean that the Fed will (1) cease interest rate increases (in 2019) based on the tightening financial conditions, and (2) will likely slowdown the reduction in the size of their balance sheet.

2. Europe extends QE and it gets authority to buy European stocks. Mario Draghi decides not to retire next year.

3. China introduces a major easing policy that has substance, clout and power.

4. Treasury Secretary Mnuchin resigns and is replaced by Hank Paulson.

5. The U.S.China trade war ends with a full resolution.

6. Democrat Joe Biden and Republican Mitt Romney, aiming at bringing back national unity, jointly declare they are running on the same ticket for President and Vice President in 2020.

7. The Mueller investigation concludes that the President was guilty of collusion and obstruction. Trump immediately resigns and Mike Pence becomes the President of the United States.

8. The SEC initiates broad reform aimed at curbing the dominance of high frequency (quant) strategies and products and reestablishing the uptick rule. Passive investing begins to lose market share to active investing.

9. On the same day that Berkshire Hathaway (BRK.A) (BRK.B) announces a premium bid for 3M (MMM) , KKR and Blackstone announce separate $25 billion acquisitions. Apple (AAPL) follows this M&A explosion with a proposed leveraged buyout, (also) partially financed by Berkshire Hathaway.

10. On the same day, 1Q2019 earnings for Amazon (AMZN) and Alphabet (GOOGL) report substantially better than expected results.

We’ll see.

Doug Kass, since 2004 Doug Kass has served as President of Seabreeze Partners Management, Inc. He runs a hedge fund and individual managed accounts, co-authored “Citibank: The Ralph Nader Report” with Ralph Nader and the Center for the Study of Responsive Law in the 1970s and wrote “Doug Kass: A Life on the Street” two years ago (John Wiley). Since 2003 Mr. Kass served as a guest host on CNBC’s “Squawk Box” and has guest hosted Bloomberg’s “Market Surveillance” for the last five years. Along with Jim Cramer, Doug is the principal contributor to Real Money Pro.