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Kass – Welcome To Hotel Europa

Written by Doug Kass | May, 30, 2018

  • The Italian crisis is not all negative to our markets
  • While the global economic cycle will be slightly downgraded, it will be elongated
  • Lower rates and inflation represent a valuation positive
  • Lowering Market Risks: Pessimistic Case Reduced (-10%), “Fair Market Value” Increases (+4%) and Upper End of Trading Range Lifted (+2%)

“Welcome to the Hotel California
Such a lovely place (such a lovely place)
Such a lovely face.
Plenty of room at the Hotel California
Any time of year (any time of year) you can find it here” – Eagles, Hotel California

While the Italian debt crisis exposes investors to the reality of a structurally unsound economic region – which principally grew due to negative interest rates – and will almost certainly serve to slow down Italy’s economy, with collateral damage in other parts of Europe, leading to slower global economic growth, modestly slower domestic economic growth and a more tepid rise in US corporate profits – there are market and economic upsides to the crisis:

  • Interest rates and inflation in the U.S. will moderate (look at the quick drop in the price of crude oil in the last week after Saudi Arabia detailed supply increases for the second half of this year) relative to previous expectations
  • Reflecting rising global economic concerns (see my notes on growing economic ambiguity), our Federal Reserve should be less restrictive and more measured in 2018-19 than the general consensus believes
  • Lower than expected interest rates will sustain the housing market (producing a more positive multiplier effect) – which was beginning to disappoint in the months of April and May under the weight of higher mortgage rates (that pressure, was only going to intensify as rates recently moved higher)
  • Moderating interest rates (relative to previous expectations) and a lengthier economic up cycle will contain corporate loan default risks over the near term (particularly given covenant lite terms)
  • Though economic growth will be slower than consensus, the threat of a swift profit margin contraction has been lessened

The bottom line is that the US economic cycle will probably be elongated – deferring my concern that rising rates and inflation would define the end of the current and nearly decade long domestic economic up cycle and negating the risks incorporated and leading to my pessimistic case for the S&P Index.

Moreover, as recently written – with so much stock locked up in Central Banks and Sovereign Wealth Funds, and with fewer companies listed and a marked reduction of outstanding shares (due to buybacks) of the existing listed companies — the market is structurally inflated to higher values.

That is not to say that global economic growth, while being sustained for longer, will be improving. It will not, and forecasts for the economy and profits will be tilted somewhat lower now. But, my view , is that the cycle’s lengthening (even though the overall growth rate will be moderating) will result in modestly higher valuations and negates the bust brought on by higher interest rates and rising inflation.

Finally, it is important to note that while contagion risk still exists – unlike previous and similar incidents in the past, so much Euro debt is held by the ECB, that the effects of a selloff of that debt will be buffered.

New Trading Range and 2018 Price Targets for the S&P Index

“Well when events change, I change my mind. What do you do?” – John Maynard Keynes

Late in the day yesterday I removed my large (SPY) short and moved from a medium sized net short exposure to a medium sized net long exposure.

For those that follow me closely this is a rare move for me – but there are a number of stocks with favorable reward versus risk in my portfolio.

So, when the facts change, I change.

This is not to say that I am bullish (as I wrote yesterday I plan to be reshorting strength and moving my invested position back down) – I am not (see rewards vs risk in my closing notes in this missive).

I still believe that the price peak in the S&P Index for the year was reached in late January, 2018.

A somewhat elongated cycle (caused by less interest rate stress) reduces the market’s downside target by 10%, slightly improves (+4%) the “fair market value” and modestly increases the top end of the anticipated trading range.

I am changing my 2018 price targets for the S&P Index:

Previous S&P Forecast:

Market Downside: 2200
‘Fair Market Value’: 2400
Trading Range: 2550-2725 to 2750

New S&P Forecast:

Market Downside: 2400 to 2450
‘Fair Market Value’: 2500
Trading Range: 2550- 2750 to 2800

Bottom Line

Most of my market concerns, expressed in yesterday’s opening missive, “The Circular Debt ‘Doom Loop’ and the End of the Epic Bond Bubble in Europe ” remain intact.

Importantly, the ECB is still ending QE by year end so Italy might be just a dress rehearsal of what’s to come as junky credit exists everywhere in the EU. And in one month, QT (over here) ramps to $120 billion in 3Q2018.

The market continues to have limited upside, but an elongated economic cycle (and less interest rate stress) likely means my pessimistic scenario (S&P 2200) has been negated for 2018.

Here are the current reward versus risk parameters (based upon the +13 handle rise in S&P futures, 2705 S&P equivalent):

1. There is 280 points of downside risk against 95 points of upside reward (compared to the top of the expected trading range) in my new pessimistic case (2400-2450)

2. Compared to “fair market value,” (2500) there is 205 points of downside risk versus 95 points of upside reward.

3. Against the expected trading range, there are 155 handles of downside risk and only 70 points of upside reward.

As you can see – all the ratios of risk are negative. The rationale for my current net long exposure (given the above risk/reward ratios) – is that I believe I have found individual stocks and sectors (like banks) with favorable reward vs risk.


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Doug Kass

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.

2018/05/30
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