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Kass: 15 Surprises for 2011

"Never make predictions, especially about the future."
-- Casey Stengel

There are five lessons I have learned since my first surprise list for 2003:
  1. how wrong conventional wisdom can be;
  2. that uncertainty will persist;
  3. to expect the unexpected;
  4. that the occurrence of Black Swan events are growing in frequency; and
  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.
Eight years ago, I set out and prepared a list of possible surprises for the coming year, taking a page out of the estimable Byron Wien's playbook, who originally delivered his list while chief investment strategist at Morgan Stanley, then Pequot Capital Management, and now at Blackstone. (Here is Byron Wien's surprise list for 2010.)

Importantly, my surprises are not intended to be predictions but rather events that have a reasonable chance of occurring despite being at odds with the consensus.

I call these "possible improbable" events. In sports, betting my surprises would be called an "overlay," a term commonly used when the odds on a proposition are in favor of the bettor rather than the house.

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The real purpose of this endeavor is to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs.

Since the mid 1990s, the quality of Wall Street research has deteriorated in quantity and quality (due to competition for human capital at hedge funds, brokerage industry consolidation and former New York Attorney General Eliot Spitzer-initiated reforms) and remains, more than ever, maintenance-oriented, conventional and group-think (or groupstink, as I prefer to call it). Mainstream and consensus expectations are just that, and in most cases, they are deeply embedded into today's stock prices.

It has been said that if life was predictable, it would cease to be life, so if I succeed in making you think (and possibly position) for outlier events, then my endeavor has been worthwhile. My annual exercise recognizes that over the course of time, conventional wisdom is often wrong. As a society (and as investors), we are consistently bamboozled by appearance and consensus. Too often we are played as suckers as we just accept the trend, momentum, and/or the superficial as certain truth without a shred of criticism.

Just look at those who bought into the success of Enron, Saddam Hussein's weapons of mass destruction, the heroic home-run production of steroid-laced Major League Baseball players Barry Bonds and Mark McGuire, the financial supermarket concept at what was once the largest money center bank Citigroup (C), the uninterrupted profit growth at Fannie Mae and Freddie Mac, housing's new paradigm of non-cyclical growth and ever-rising home prices, the uncompromising principles of former New York Governor Eliot Spitzer, the morality of other politicians (eg, John Edwards, John Ensign and Larry Craig), the consistency of Bernie Madoff's investment returns (and those of other hucksters) and the clean-cut image of Tiger Woods.

In an excellent essay published over the past week, GMO'S James Montier makes note of the consistent weakness embodied in consensus forecasts.

Attempting to invest on the back of economic forecasts is an exercise in extreme folly, even in normal times. Economists are probably the one group who make astrologers look like professionals when it comes to telling the future. Even a cursory glance at Exhibit 4 reveals that economists are simply useless when it comes to forecasting. They have missed every recession in the last four decades! And it isn't just growth that economists can't forecast: it's also inflation, bond yields, and pretty much everything else. If we add greater uncertainty, as reflected by the distribution of the new normal to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!
For 2011, consensus estimates for economic growth, corporate profits, stock price targets and interest rates are grouped in an extraordinarily tight range. I have chosen to use Goldman Sachs' (GS) forecasts as a proxy for the consensus.

Here are Goldman Sachs' principal views of expected economic growth, corporate profits, inflation, interest rates and stock market performance:

  • 2011 GDP up 3.4% (global GDP up 4.7%);
  • 2011 S&P 500 operating profits of $94 a share;
  • year-end S&P 500 price target at 1,450 (a gain of about 15%) ;
  • 2011 inflation of 0.5%; and
  • the 2011 closing yield on the US10-year Treasury note at 3.75%.
Looking beyond 2011, it appears that the consensus further expects that the domestic economy is well on its way toward delivering a smooth and self-sustaining and normal historical recovery that (from start to finish) should last about four years. The clustering of that consensus suggests that any short- or intermediate-term variant outcomes could be destabilizing to the markets, both to the upside and to the downside.

To some degree, my surprises for 2011 attack some of the similar, non-variant and nearly universally optimistic expectations on the part of money managers, strategists, economists and members of the fourth estate. As such, I want to emphasize that my intention is not to be a Cassandra or to be a contrarian for contrary's sake but rather to recognize that most prefer the dreams of the future to the history of the past. My surprise list for 2011 recognizes an often repeated lesson of history: What seems easy for (bullish) investors to imagine today might prove more difficult to deliver, as prospect is often better than possession.

More than almost any time I can remember, there exists few variant views relative to consensus as we enter the New Year. Perhaps leading that minority is Gluskin Sheff's David Rosenberg, who, though thoughtful and thorough in analysis, is pigeonholed by the media as a dogmatic standard-bearer for the bear case. (Rosenberg succinctly underscores and questions the universal optimism in his commentary this week.)

"Those who cannot remember the past are condemned to repeat it."
-- George Santayana
Looking at history, there was no better example of misplaced optimism than in the period leading up to the Great Decession of 2008-2009, providing a vivid reminder of the poor forecasting ability and investment risks associated with the crowd's baseline expectations and the value of a surprise list that deviates from that consensus.

Only the remnants anticipated anything near the magnitude of the fall in the world's economies and capital markets, despite what appeared to be clear and accumulating evidence of economic uncertainty and growing credit risks (and abuses). The analysis of multi-decade charts and economic series convinced most (along with other conclusions) that home prices were incapable of ever dropping, that derivatives and no-/low-document mortgage loans were safe, that there was no level of leverage (institutional and individual) too high and that rating agencies were responsible in their analysis. Importantly, they also failed to see the signposts of an imminent deterioration in business and consumer confidence that was to result in the deepest economic and credit crisis since the early 1930s.

From my perch, many of those who are now expressing the most extreme levels of optimism were the most wrong-footed two years ago and experienced not inconsequential pain in the last investment cycle. (Perhaps the recovery in equities was so swift in time and sizeable in magnitude that memories have been simply erased to the risks that are still omnipresent today.)

Back then and, to a lesser degree, today, many investors appear similar to victims of Plato's allegory of the cave, a parable about the difficulty of people who exist in a world shaped by false perceptions to contemplate truths that contradict their beliefs. This is why so many investors were blindsided by the last downturn and, from my perch, continue to remain conditioned to wearing rose-colored glasses.

In the famous simile of the cave, Plato compares men to prisoners in a cave who are bound and can look in only one direction. They have a fire behind them and see on a wall the shadows of themselves and of objects behind them. Since they see nothing but the shadows, they regard those shadows as real and are not aware of the objects. Finally one of the prisoners escapes and comes from the cave into the light of the sun. For the first time, he sees real things and realizes that he had been deceived hitherto by the shadows. For the first time, he knows the truth and thinks only with sorrow of his long life in the darkness.
-- Werner Heisenberg,Physics and Philosophy
Last year's surprise list had relatively poor results. Only about 40% of my surprises were achieved in 2010, well under the success ratio in previous years. By means of background, about 50% of my2009 surprises were realized, 60% in2008, 50% in2007, one-third in 2006, one-fifth in 2005, 45% in 2004 and one-third came to pass in the first year of our surprises in 2003.

While my surprise list for 2010 hit on some of the important themes that dominated the investment and economic landscape this year, I failed to expect the announcement of further quantitative easing and did not accurately gauge investors' animal spirits that followed the proclamation of QE2.

Here is a list of some of my meticulous surprises from last year's list:

  • Economy. Real GDP and corporate profit growth was, as I suggested, far better than expected during the first half of 2010, and my surprise that US equities would weaken (and that P/E ratios would contract) despite that strength was accurate (in that stocks exhibited a negative return during that period).


  • Housing and jobs. Despite the overall economic strength, both housing and employment failed to recover.


  • Interest rates. My surprise that the yield on the 10-year US note would fall under 3% by midyear and end 2010 at about 3% was prescient.


  • SEC investigations. The broadening of the SEC's assault on insider trading was a featured story in 2010.


  • The Oracle of Omaha. Though Warren Buffett is still at the helm, our surprise that he would announce a possible successor was accurate.


  • Hedge funds. Brilliant and legendary hedge-hogger Stanley Druckenmiller announced that he was leaving the investment business -- in line with our surprise that a leading hedge-hogger would announce his retirement.
What follows is my list of 15 Surprises for 2011 -- reduced from 20 surprises in previous years in order to be more on point. I have listed my surprises in four categories -- economic (surprise No's. 1-3), stock market (surprise No's. 4-6), political (surprise No's. 7-9) and general (surprise No's. 10-15).

1. In line with consensus, the domestic economy experiences a strong first half, but several factors conspire to produce a weakening second half, which jeopardizes corporate profit growth forecasts.


  • The improving momentum of domestic growth at the end of 2010 continues into the first half of 2011 but proves ephemeral by the summer.


  • That improving momentum turns out to be nothing more than a brief respite and "recession fatigue," as reality and a new normal sets in.


  • Americans remain in a foul mood, as the jobs market fails to improve despite the recent downtick in claims.


  • Over there, multiple country austerity programs move Europe back into recession by year-end 2011. (Share prices of many large multinational industrials falter in the year's second half.)


  • China continues to tighten, but inflation remains persistent, economic growth disappoints (see surprise No. 15), and its stock market weakens further.


  • Political gridlock and inertia in tackling the deficit incite the bond vigilantes. The yield on the 10-year US note rises above 4.50% by the spring (see surprise No. 2).


  • Trust continues to be lost, as the uncertainty brought by changes in the administration (see surprise No. 7) and the emergence of a third political party (see surprise No. 8) adversely impacts consumer and corporate confidence.


  • Housing fades under the pressure of higher mortgage rates and the supply of shadow inventory coming onto the market in an avalanche of foreclosures. (A housing czar is named to implement a Marshall Plan for housing.)


  • An across-the-board spike in commodities pressures corporate profit margins and real disposable incomes (see surprise No. 3).


  • Price controls are briefly considered (and then rejected) by the Obama Administration as oil soars to over $125 a barrel.
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