Monday, July 27, 2009

Kass: Updating the Model Portfolio

Doug Kass

07/27/09 - 12:01 PM EDT
This blog post originally appeared on RealMoney Silver on July 27 at 8:38 a.m. EDT.

In late April, I initiated the Kass Model Portfolio, intended to represent the general construction of a long-only model portfolio with a six- to 12-month investment horizon. My hypothetical portfolio depicts an overall equity weighting and positioning relative to S&P 500 industry benchmarks and weightings.

As I did in calling for a generational bottom in early March, I am again adopting a variant and unpopular view, but this time it is a more negative call. It is important to emphasize that in my March call, I expected a resurgence of economic and investment optimism during the summer to be followed by a multiyear period of weak investment returns. Specifically, I expected a mini production boom and an asset allocation away from bonds and into stocks to be embraced and heralded by investors, who would only be disappointed again in the fall as it becomes clear that a self-sustaining economic recovery is unlikely to develop.

Today's opening missive has another major change in our model portfolio, with a further increase in the cash component of the portfolio from 29% to 43%. I am further reducing both equity and credit exposure after a huge run in both asset classes.

As I see it, the bull market argument is that we are exiting the recession just like the many that preceded the current one. Consequently, corporate profits will exceed consensus forecasts in tandem with:

  1. the resumption of revenue growth (seen in three months of improvement in the leading economic indicator, signs of stabilization in housing, etc.);

  2. the record fiscal stimulation;

  3. an export-led Asian recovery; and

  4. the operating leverage associated with productivity gains achieved through draconian cost cuts and influenced by tame wage inflation.

Besides productivity being underestimated the bulls, further argue Say's Law of Production -- that it is business that drives consumer incomes and spending. Finally, the bullish cabal argues that the high-tax health and energy bills introduced by the President have been recently set back as the blue dog democrats and the liberal leadership are already battling.

The bear market argument (that I now endorse) is that we are seeing nothing more than a second derivative recovery and that owing to a temporary replenishment of inventories, the economy is only getting less worse (or getting better from a depressed level). From my perch, the ingredients for a durable and self-sustaining recovery are missing. An economic double-dip grows more likely in a climate of corporate cost cuts, which elevates jobless rates and leads to continued pressure on personal consumption expenditures. The bears reject Say's Law of Production and view consumer incomes and spending as driving business.

Importantly, the economic downturn of 2007-2009 has already been different this time in scope and duration. For example, unlike the other post-depressions/recessions of the last century, we have already witnessed two consecutive quarterly drops in nominal GDP. As well, the 20-month-old recession has resulted in a near 4% drop in real GDP vs. drops of between 2.5% and 3.0% in the mid 1970s and early 1980s recessions. The U.S. economy came out quickly from those prior downturns, with recoveries to new peaks in economic activity taking only three or four quarters.

My view, however, is that it is different this time: The typical self-sustaining economic recovery of the past will not be repeated in the immediate future for 10 important reasons that will come to the fore:

  1. Cost cuts are a corporate lifeline and so is fiscal stimulus, but both have a defined and limited life.

  2. Cost cuts (exacerbated by wage deflation) pose an enduring threat to the consumer, which is still the most significant contributor to domestic growth.

  3. The consumer entered the current downcycle exposed and levered to the hilt, and net worths have been damaged and will need to be repaired through higher savings and lower consumption.

  4. The credit aftershock will continue to haunt the economy.

  5. The effect of the Fed's monetarist experiment and its impact on investing and spending still remain uncertain.

  6. While the housing market has stabilized, its recovery will be muted, and there are few growth drivers to replace the important role taken by the real estate markets in the prior upturn.

  7. Commercial real estate has only begun to enter a cyclical downturn.

  8. While the public works component of public policy is a stimulant, the impact might be more muted than is generally recognized. There may be less than meets the eye as most of the current fiscal policy initiatives represent transfer payments that have a negative multiplier and create work disincentives.

  9. Municipalities have historically provided economic stability -- no more.

  10. Federal, state and local taxes will be rising as the deficit must eventually be funded, and high-tax health and energy bills also loom.

As I wrote last week, the most disturbing feature of the current business environment is the manner in which corporations are beating estimates. While it enhances the present profit configuration, it has the potential for a long and negative tail to the future. Cost-cutting, like another man's bread, will line the corporation with profits but, in the fullness of time, will not fill the belly of the consumer who is the victim of the realignment of expenses. Costs cuts have a finite life, and, as such, produce an inherently lower quality of earnings and a less positive lever to P/E multiples than does the classical cyclical improvement in top-line or sales growth.

Given the unusual nature and the severity of the downturn, it is hard for me to see anything typical about the domestic economy's rebound compared to previous recovery periods. I do not see the disproportionate role of housing and credit in the prior decade being replaced by anything similar as a growth lever in 2009-2011. Already job losses are unprecedented and cost-cutting's impact on unemployment will exacerbate pressures, acting as a greater drag in the years ahead. Meanwhile, other (nontraditional) headwinds -- such as the likely growth-inhibiting public tax policy, less available credit and an intrusive public sector's interference on the private sector (with attendant regulatory costs and burden) -- will weigh heavily on the economy. So will bloated budgets and poor planning, which have left municipalities in disarray, raise unfamiliar cyclical challenges.

My contacts with corporations are universally more downbeat than the optimism expressed by investors recently. Many in my hedge fund cabal say that this input from the industry is not unexpected, as company managements universally failed to see the coming downturn. This is a fair response, but I suppose they could be right for a change!

For now, the animal spirits are in force. Shorts are covering, and the longs are joining the ever more vocal and growing bullish chorus in the face of the enemy of the rational buyer -- namely, optimism.

In summary, my model portfolio's high cash position reflects a less optimistic view of the sustainability of corporate profit and economic growth as well as a renewal of excessive optimism in sentiment and a move toward more elevated valuation levels (which are not supported by the profit picture I foresee).



S&P Weighting Recommended Weighting Rationale for Weighting
Technology 18% 8% Business spending will remain subdued, and the sector is now overowned
Financials 13% 7% The risk of a double-dip augurs poorly for credit metrics
Energy 13% 5% Commodities, like energy products, are vulnerable to a slowdown
Health Care 13% 5% Government intervention threatens pricing
Consumer Staples 12% 5% Exposed to generic trade-down as consumer weakens
Industrials 10% 5% Shallow and uneven economic recovery remains a headwind
Consumer Discretionary 9% 4% Accumulated job losses and wage deflation weigh on consumer
Materials 4% 2% Shallow and uneven economic recovery remains a headwind
Utilities 4% 2% Exposed to a further spike in interest rates
Telecom 4% 4% Secular prospects remain strong
Total equities 100% 47%
Credit 0% 10% Opportunistic
Total exposure 100% 57%
Cash 0% 43%

Finally, I have included a shopping list of individual stock candidates (by sector) that could be considered in the aforementioned Kass Model Portfolio.

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Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.