Kass and Housing

From the current Kelly Letter research stream come these two points.

Doug Kass has been the man of the year as far as market forecasts go because he confidently called a generational low in early March, as most of the herd fretted slipping into the abyss. From 666 on the S&P; 500, Kass said we’d see 1050 by late summer or early fall, then take another trip lower. He still thinks so, and says the time frame is right on track. From an article he wrote yesterday at TheStreet.com:

Arguably, today investors face the polar opposite of conditions that existed only a few months ago, with economic optimism, improving valuations and positive sentiment.

To most investors, today the fear of being in has now been eclipsed by the fear of being out as the animal spirits are in full force. Bears are now scarce to nonexistent in the face of steady price gains in equity and credit prices.

The primary question to be asked is, Will the earnings cycle dominate the investment landscape and cause investors to overlook the chronic and secular challenges facing the world’s economies, particularly as the public sector stimulus is eventually withdrawn and paid for and the economic consequences of the massive public sector intervention manifest themselves in the form of higher interest rates and marginal tax rates?

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.

Just as I looked over the valley in March 2009 toward the positive effects of massive monetary/fiscal stimulation within the framework of a downside overshoot in valuations and remarkably negative sentiment, I now suggest another contrarian view is appropriate as I look over the visible green shoots of recovery toward a hostile assault of nonconventional factors that few business/credit cycles and even fewer investors have ever witnessed.

A double-dip outcome in 2010 represents my baseline expectation. When the stimulus provided by the public sector is finally abandoned, it seems unlikely to be replaced by meaningful strength or participation by any specific component of the private sector, and the burgeoning deficit (described above) will ultimately require a reversal of policy, leading to higher interest rates, rising marginal tax rates and a lower U.S. dollar. My forecast assumes that the market’s focus will shortly shift from the productivity gains that have been yielding better-than-expected bottom-line results toward these chronic and secular worries.

Markets top during times of enthusiasm. I believe that the markets are now overshooting to the upside and that the U.S. stock market has likely peaked for the year.

That becomes all the more meaningful in light of the announcement earlier this week that the Obama administration underestimated the deficit by $2 trillion. Higher taxes and cutbacks in government programs are inevitable. Those will reduce consumer spending, the heart of the U.S. credit based economy, which will make the business environment far less hospitable than we’re used to seeing.

Another point of concern is housing, which is by no means fine, as some already contend. Half of homeowners are destined to be under water on their mortgages next year, as explained by these excerpts taken from an article at MSNBC:

More than 13 percent of homeowners with a mortgage are either behind on their payments or in foreclosure, the Mortgage Bankers Association said Thursday. As of June, more than 4 percent of all borrowers were in foreclosure and about 9 percent had missed at least one payment. A separate report found that more than 272,000 borrowers were at some stage of foreclosure in July, up 8 percent from June and 55 percent from July 2007, according to RealtyTrac, which maintains a national database of foreclosure filings.

The continuing rise in foreclosures delays any meaningful recovery in the U.S. economy, in part because housing typically leads the economy out of recession. Every new foreclosed home increases the unsold inventory on the market and cuts into demand for new construction.

Foreclosed homes push nearby home prices lower. Unless the pace of foreclosures can be slowed, millions more homeowners will be forced “under water”. Roughly half of all U.S. homeowners will be under water by 2011.

That notion is confirmed daily in the Kelly Letter email inbox, where subscribers and other readers tell me financial stories about the people in their lives. It’s ugly out there. People are hunkering down, some by choice but others out of necessity.

Neither is good for the economy.

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