Kass: Equities Edge Toward a Top

Doug Kass

10/19/10 - 02:00 PM EDT

This blog post originally appeared on RealMoney Silver on Oct. 19 at 9:13 a.m. EDT.
 
I find myself back to taking the (market) road less traveled once again as investors' unjustified blind faith in the success of QE 2 has increased the U.S. stock market's degree of risk relative to the reward.

Let me start by emphasizing that the precision of stock market forecasts in a market dominated by algorithms, momentum players and even mob psychology is an increasingly difficult exercise, but I will try nonetheless.
In early July 2010, when the S&P 500 was plummeting and closing in on the 1,000 level, I suggested that the scale had tipped to the bullish side and that equities were in the process of making the lows for the year.
Since then, buoyed by the notion that the prospects for an open-ended QE 2, which would be aimed at lowering real interest rates, raising inflation rates and have a strategy that might even be targeted at the S&P 500 in order to elevate the U.S. stock market, equities have leapt forward for weeks in a routine and consistent fashion.

In light of what I expect to be a disappointing economic impact from QE 2 -- I call it quantitative wheezing -- and the negative consequences of that strategy ("screwflation") on the majority of Americans, I now believe that equities are in the process of putting in the highs for the year.

After spending like drunken sailors during the Bush administration, Republican legislators have acknowledged that it will block even the most sensible stimulus programs, and the Democratic administration and its legislators have lost the will to fight their adversaries. As a result, the responsibility for turning around the domestic economy now lies squarely on the shoulders of the Fed.

The implementation of QE 2 during the first week of November is now a virtual certainty. The general belief in its efficacy has vaulted stock markets around the world considerably higher.

The markets believe that unusual, definitive and targeted monetary solutions will solve deep-rooted problems that, in the past, were put on the shoulders of fiscal policy (e.g., a tepid jobs market).

On Wall Street, we too easily extrapolate trends. Whether it's company earnings or industry statistics or economic recoveries, policies and rescue packages, investors want to believe in the more or most favorable outcomes. So, we are told by David Tepper, Wall Street strategists and most long-biased investors that if the liquidity infusion from the first round of quantitative easing worked in the U.S., it has to work in QE 2.
Throughout the market's rally over the past six weeks, I was reminded something Milton Friedman's once expressed, which I have taken the liberty of paraphrasing below to emphasize my concerns with regard to the efficacy of QE 2: If you put the Federal Reserve in charge of the Sahara Desert, in five years, there would be a shortage of sand.

We have embarked on a slippery slope of policy, and, from my perch, there is too much confidence regarding a favorable outcome.

Is it really a good idea to put our investment trust in the successful policy of the Federal Reserve in its ability to fine tune inflation and stimulate growth? After all, in the past the Federal Reserve couldn't find their way home and failed to identify the stock market bubble in the late 1990s, the housing bubble in 2003-07 and the recent credit bubble.

In a recent interview with Fortune Magazine's Carol Loomis, Warren Buffett said that he "can't imagine anybody having bonds in their portfolio." (I continue to believe that short bonds is the trade of the decade.) At the same time, Fed Chairman Ben Bernanke is hellbent on buying U.S. bonds ad infinitum. As my buddy/friend/pal, Jeff Matthews, recently wrote, Who do you have more confidence in making your investment decisions -- Berkshire Hathaway's (BRK.A) Warren Buffett or the Federal Reserve's Ben Bernanke?

Most market participants are fixated with the potential for QE 2 to boost asset prices and generate organic economic growth, however, without a subsequent rise in aggregate demand and productivity, the program will ultimately be deemed a failure as prices readjust over time to reflect the real underlying fundamentals. Mr. Bernanke is making the same blunder that we made with the past bubbles busts -- if we can create paper profits and convince consumers that they should spend those paper profits, then we'll be on our way to economic prosperity. The problems arise when asset prices readjust lower to meet their true fundamentals. It's Ponzi finance and nothing more. -- "Northern Trust: QE 1 Failed, Why Will QE 2 Work?" from Pragmatic Capitalism

As I have written previously, I don't believe QE 2 will meaningfully move the needle of domestic economic growth and will only have a limited impact on:

• the jobs market, which is plagued by structural unemployment;
• housing, which that is haunted by a large shadow inventory of unsold homes and in which mortgage credit will likely be further reduced by the moratorium on foreclosures; and
• confidence, which is still mired in uncertainty regarding regulatory and tax policy (and that is undermined by high unemployment).

Conditions are far different for QE 2 than QE 1. Interest rates have already fallen to very low levels, and the benefits have already been felt on mortgage rates and in refinancing. Also, unlike QE 1, when the world's central banks were all-in, differing policies now dominate the global landscape.

Meanwhile, our fiscal imbalances multiply, our currency craters (as a worldwide rush to currency devaluation is offsetting some of the normal trade deficit benefit), and the bulls rationalize these concerns by suggesting that the consequences "are beyond our investment time frame."

Importantly, there are a number of other possible adverse consequences from the inefficient allocation of resources that is the outgrowth of the next tranche of monetary stimulation.
While the immediate response to the likelihood of QE 2 has been to buoy asset prices, the domestic economy is stalling at around 1.5% to 2.0% GDP growth, and little improvement in the jobs market has been seen. This hesitancy makes the anemic slope of the current recovery vulnerable to the unforeseen (e.g., trade wars, policy errors, etc.) and could place the generally assumed self-sustaining economic cycle at risk. As well, the long tail of the last cycle's abusive use of credit looms large, as demonstrated by mortgage-gate.
My bottom line is that QE 2 will have only a modest effect on the broad economy. Our largest corporations will fare better as interest rates drop and will profitably extend their debt maturities in a cheap and hospitable bond market, but, as commodities rise, some troubling consequences could emerge.
We are not on a road to the stagflation of the 1970s, but we may very well be on the road to screwflation.
Screwflation, like its first cousin stagflation, is an expression of a period of slow and uneven economic growth, but, its potential inflationary consequences have an outsized impact on a specific group. The emergence of screwflation hurts just the group that you want to protect -- namely, the middle class, a segment of the population that has already spent a decade experiencing an erosion in disposable income and a painful period (at least over the past several years) of lower stock and home prices. Importantly, quantitative easing is designed to lower real interest rates and, at the same time, raise inflation. A lower interest rate policy hurts the savings classes -- both the middle class and the elderly. And inflation in the costs of food, energy and everything else consumed (without a concomitant increase in salaries) will screw the average American who doesn't benefit from QE 2.
In summary, somebody holds the key to a self-sustaining domestic economy, but I doubt that it is a monetary maven, as some of the potential side effects of quantitative easing might be worse than the medicine. And the confidence and animal spirits that the markets have expressed since early September might just be blind faith.
The domestic economy remains in a contained recession, and, while containment efforts will continue with QE 2, the efficacy of these efforts will likely disappoint and wane.
I continue to see the risks to 2011 corporate profit and U.S. and worldwide economic growth rates to the downside. It remains likely that secular and nontraditional headwinds will produce an extended period of inconsistent and uneven growth in the years ahead, which will be difficult for both corporate managers and investment managers to navigate. Arguably, given the sharp rise in equities, the downside risks might be growing ever greater, especially if I am correct that QE 2 will be a dud.
The key to remedying today's low P/E multiples would be to apply the same amount of attention, brain power and solutions spent on short-term policy (which invariably makes things worse) on the underlying structural problems that our country faces.
But, patience, more than policy, is something that investors, politicians and others have precious little of these days.