Doug Kass: Market Risk Vs. Reward Ain't Lookin' Good
Equities haven't been this unattractive since late 2021.
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My commentary today is decidedly downbeat, some might even say dystopian. But I think my concerns are largely justified. Importantly, with markets trading at a 22-times forward price earnings multiple, there is little room for disappointment.
Adverse outcomes are likely to become more common place in the time ahead. Just take the recent juvenile and angry Elon Musk vs. President Trump exchanges. Never in my investing career has there been so many possible social, political, geopolitical, economic, interest-rate and fiscal policy outcomes.
Many of these possible outcomes could easily upset overvalued markets. Based on my calculus and scenario analysis, the market’s downside risk is roughly 5-times the market’s upside reward — this is the worst ratio since late 2021.
To put this in perspective, here is a compilation of my recent columns in my Daily Diary on The Street Pro as well as my commentary to my hedge fund (Seabreeze Partners) investors:
Cutting Deficits: Great in Theory, Impossible in Practice
Americans unfortunately continue to be exposed to unvarnished political self-interest, the continued loss of conventions and general lack of ethics and morals. An example is the insider trading of our Congressional members, right in front of our eyes. It is increasingly obvious that political positions of influence can easily be bought — sold by both Democrats and Republicans. To this observer, fewer and fewer politicians are even pretending that they care about the American people. This may help to explain the capital outflows out of the U.S. and that many (including ourselves) are "Rethinking American Exceptionalism." (Consider what the world outside of the U.S. thinks of us these days).
As dark as all this is, my concerns relate to both parties. The Republican party has its own set of issues while Democratic leadership doesn't even seem to exist — making the situation rather sickening. This concerning condition has real economic and investment consequences, most importantly as reflected in the continuing lack of fiscal discipline and unwillingness to address our country's debt load. I express this reality and these conditions not as political statements, but rather as economic and investing considerations. It is highly unlikely that any politician on either side of the pew will address our progressively and steadily deteriorating financial position. At this point, if they did recommend some hard decisions, they would likely be voted out of office. There are simply too many forces inside the government opposed to cutting spending to produce meaningful results — just look at the resistance to DOGE.
Whether the "big, beautiful bill" increases or decreases the deficit by a few trillion dollars has now lost its relevance. We have already lost the ability to control the deficit — as the total federal debt load is now projected to be nearly $50 trillion in 2030 and over $70 trillion by 2040. The harsh truth is that it is getting almost too late to dent the deficit (and the arc toward an erosion in U.S. solvency) without radical changes in non-discretionary spending and/or taxation requiring austerity and large tax increases (which would trigger a severe recession). As a consequence of the above factors (and other influences) interest rates will stay higher for much longer — an unfriendly condition for future price earnings ratios (as interest rates are at the core of all equity valuation models). Additionally, higher interest rates (and deficit neglect by our representatives in Washington, D.C.) will result in sharply rising costs of servicing our burgeoning debt load.
Why the Market Responds Poorly to Cooler Inflation Print
As noted on Wednesday, while investor rejoiced in response to the better inflation release, I by contrast grew more negative (and added to my short exposure):
If you read JPMorgan's CPI scenario analysis you will see that given the colder inflation print this morning, the brokerage expected more than a +2% positive reaction to the print (they and others were disappointed!) :
· [5.0% probability] Core MoM prints below 0.25%. SPX gains 2%-2.5%. The other tail outcome, similar to recent results from EU/UK, this would be a material dovish print. Look for the bond market to add back at least 2x 25bp rate cuts and for equities to react positively to the bull steepening that likely ensues.
The reasons I think they were wrong in anticipating a +2% or better rise yesterday in the S&P are because
1) the market has likely already discounted a better than expected Core CPI,
2) the China/US tariff meeting ended up being a complete non-event with no evidence of reducing tariffs,
3) Investor may interpret this number as being less exciting for equities because companies/manufacturers are likely eating the higher costs/ tariffs, leading to concerns about lower margins and profits over the balance of the year and,
4) based on the swings in the trade balance, importers stockpiled stuff ahead of Liberation Day — so they had product in inventory to sell without tariff penalties... When that inventory runs out, they will likely have to put through price hikes and inflation will heat up.
From my pal, Richard Bernstein:
Bottom Line
To summarize my ursine market view:
* Political and geopolitical polarization and competition will probably translate into less political centrism and a reduced concern for deficits — creating structural uncertainties, limited fiscal discipline and imprudence around the globe ... and for the possibility of bond markets to "disanchor."
* The cracks in the foundation of the bull market are multiple and are deepening, but they are being ignored (as market structure changes have led to price momentum (fear of missing out) being favored over value and common sense).
* With the S&P 500 Index at around 6000, the downside risk dwarfs the upside reward for equities — in a ratio of about 5-1 (negative).
* Valuations (a 22-times forward Price Earnings Ratio) and (consensus) expectations for economic and corporate profit growth are all inflated.
* Being dismissed are JPMorgan CEO Jamie Dimon's and others’ dour comments on complacency and a view that the corporate credit market is "ridiculously over-stretched.”
* Look for the soft data (see last week's weak ISM and climb in jobless claims) to move into (and weaken) the hard data led by a slowing housing market likely to provide ample near-term evidence of the exposure and vulnerability of the middle class.
* Below trend-line economic growth (housing will lead us lower) coupled with sticky inflation lie ahead ("slugflation") — uncomfortable for a Federal Reserve which has to make increasingly more difficult decisions.
* Corporate profit growth (rising +13% in 1Q2025) will markedly decelerate in this year’s second half.
* The equity risk premium is at a two-decade low - typically consistent with a slide in equities.
* The S&P Dividend Yield is at a near record low of 1.27% — and the spread between the dividend yield and the 10-year U.S. Treasury note yield has rarely been as wide. With so many possible adverse outcomes, my baseline expectation is for seven lean months ahead over the balance of 2025:
"In the Bible, 'lean years' refer to a period of famine that follows a time of abundance, particularly in the story of Joseph in Genesis 41. The prophecy, revealed through dreams to Pharaoh, foretold seven years of great plenty in Egypt, followed by seven years of severe famine. Joseph, interpreting the dream, advised Pharaoh to prepare for the lean years by storing grain during the period of abundance. This preparation allowed Egypt to survive the famine while other surrounding lands suffered greatly."
Nothing Can Go Wrong, 'Buy the Dips'
I wanted to end this commentary with a thoughtful list of (bearish) present conditions and concerns, sent to me over the weekend by my dear friend David Rocker (a political independent who founded the successful hedge fund Rocker Partners) — it bears reading:
- The economy is clearly slowing and earnings estimates for the S&P 500 have been declining
- Price Earnings ratios are at a historically high range
- President Trump’s pre-election claims largely unfulfilled
- Conflict between Russia and Ukraine continues and efforts to solve it alienates our ally and favors Russia
- Mideast conflict continues with no end in sight
- No Iran solution and it refuses to stop enriching
- The Administration announces huge tariffs which threaten further inflation and worsen international relations
- The Administration's claims that negotiating with major trading partners will produce favorable pacts unfulfilled
- DOGE has been a failure - minor savings at great social cost which alienates many including many Republicans
- President Trump's personal support from swing voters that got him elected (women, Latinos, blacks) reversing
- The Big Beautiful Bill will worsen deficits and losing support
- Relentless attacks on law firms and the legal system
- Relentless attacks on major universities which are the envy of the world and key to many scientific advances
- Relentless efforts to force the FED to lower rates
- Firing of many regulators who could challenge President Trump's programs
- Vitriolic breakup with Musk, the President's chief financier
- Continued attempts to disregard legal rulings made against the Administration's program
- Worsening relationships with US's historical allies, weakening our influence:
* Resulting in worldwide loss of confidence in the United States
* The US credit rating is downgraded
* The US Dollar falls 8% worsening the purchasing power of Americans and making foreign investors wary about financing our deficit
* University attacks leading capable foreign students to consider studying elsewhere than in the US
* Tourism declining
David concludes by writing:
“Yet stocks are at a high level and the market reacts briefly and modestly to real negative setbacks but grows vigorously stronger to rumors to talks and future meetings. It seems that nothing can go wrong — as traders and investors buy the dip”.
Until it doesn't. Earlier I quoted Yogi Berra. I wanted to close by quoting him again: "It's not over til it’s over."
This commentary was originally posted in Doug's Daily Diary on TheStreet Pro.
At the time of publication, Kass was short SPY (M), QQQ (M).
