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  • Doug Kass accurately predicted the recent market rally.
  • Stocks have made a big move, testing the upper limit of Kass's 3700-4100 S&P 500 target range.
  • Kass thinks the risk-to-reward for stocks is currently unfavorable.

In December, hedge fund manager Doug Kass issued an unexpected declaration. In his annual “Surprises” feature on Real Money Pro, he said that stocks could mount a surprising rally in the first half of 2023. Today, that prediction looks prescient. But it drew more than its fair share of criticism at the time.

After a dismal first half last year, stocks appeared to find their footing (again) in October. However, a sell-off in early December fueled by tax-loss harvesting and looming redemptions frustrated bulls (again). As a result, investors were knee-deep in worry that persistent inflation, recessionary risk, and dismal earnings would prevent any stock market upside when Kass offered up his take on first-half strength.

Although many were skeptical, we pretty much got what Kass anticipated. We didn’t reach his 10% first-half gain target, but the S&P 500 climbed 5%, and the NASDAQ Composite gained nearly 9% within the year's first two weeks. Of course, many stocks were up much more than that.

What’s Kass think now? In a Real Money Pro diary post today, he paints a less-than-enthusiastic picture of what could be next for stocks.

A self-described contrarian with a calculator, Kass is happiest when the masses are against him. Go against the crowd thinking has treated him well over a career stretching back decades, including last year when he accurately predicted stocks would struggle.

Rather than chasing stocks up or down, Kass has crunched numbers to create a valuation range within which he believes the S&P 500 will remain this year. That 3700 to 4100 range serves as his objective guide. If the upside to the top end outweighs the downside to the bottom, he’ll tilt long. If not, he’ll tilt the assets in his hedge fund, Seabreeze Partners, short.

Unfortunately for the bulls, the S&P 500’s rapid ascent lifted it as high as 4040 on Monday, putting it within spitting distance to Kass’ upside target. As a result, Kass reined in longs and began opportunistically shorting. For example, Kass shorted Microsoft  (MSFT)  yesterday before disappointing earnings guidance (he covered with a nice gain this morning).

Kass's post covers important ground, so I'm including it in its entirety.

He writes:

“Minding Mr. Market and Staying Independent and Rigorous in View

Over the last week, as repeatedly written in my Diary, I have dramatically and tactically reduced my net long exposure.

In doing so, I explicitly rejected the strong price momentum, the emerging breadth thrusts, and the growing optimistic "Groupstink." Rather, I placed my emphasis on the fundamental calculation of the market's "fair market value." While that intrinsic value calculus is only as good as the input - it has provided me with a framework for the projected trading range in the S&P Index of between 3700-4100.

This math is not foolproof, nor is it meant to be precise. As written, it's only as good as my assumptions and probabilities associated with five different economic scenarios, from very pessimistic to very optimistic.

But what this exercise does is help me outline a map for gauging upside reward vs. downside risk. And, importantly, it gives me the confidence to dispassionately zig when they are zagging.

The higher stock prices rise with no change in the fundamental backdrop, the less attractive equities are. The lower prices decline again, with no change in outcome expectations, the more attractive stocks are.

Microstoned

Until the close of trading on Tuesday and before Microsoft's delivery of poor guidance (relative to expectations - more on Mr. Softee later this morning), the market extended its Friday-Monday gains as it, once again, mounted an impressive rise from the morning depths.

Despite the growing optimism - particularly from the "Moving Monkeys" - who know everything about price and nothing about value - I continued to reduce my net long exposure on the market's strength.

At about 5:30 pm last night, MSFT lowered the boom, and the optimism that existed after the initial "in line" EPS report dissipated quickly - Microsoft's +5% post-market rally morphed into a -2.5% loss for a stunning -7.5% reversal in a matter of minutes, as the company fessed up to slowing corporate software and cloud sales. Risk on, for the broader market, became risk on - post haste - with Amazon  (AMZN) , Alphabet  (GOOGL) , and other large-cap tech stocks moving swiftly from green to red by 6 pm.

My contempt for "instant analysis" in the business media was summarized in these sentences in my Diary last night:

" It is amusing to watch talking heads (who are generalists) talk about a company's results, like (MSFT) - without even having had the time to fully read the company's EPS release.

But, far more important is to make investment conclusions based on a rearview mirror analysis of the last quarter's results before the company provides guidance in about 15 minutes.

Instant analysis is like fast food -- it goes down easily but is not healthy for you."

Bottom Line

Whether one's modus operandi is technical, fundamental, or both, it is essential to stick to your knitting... and not to stray.

Reject "Groupstink" and think independently.

And, pay no attention to the non-rigorous who are miles long and inches deep - who repeatedly steer the lemmings over the cliff, time and time again.

In fact, hide your children and your portfolios from them!”

The Smart Play

The market is in Doug’s “chop bucket.” Stocks have made an impressive move and remain nicely above last year’s June and October lows. That’s encouraging for long-haul investors, but shorter-term, more active investors must remember that stocks don’t go up or down in a straight line. Plenty of zigs and zags along the way could create opportunity or risk, depending on how you handle them.

If you want to make a range similar to Kass’s, consider the S&P 500’s likely earnings per share this year, and the potential multiple-to-earnings (P/E) investors are willing to pay when optimistic or pessimistic. Remember, when money is cheap, multiples expand, and investors are willing to pay more for future cash flows. When money is pricier, like now, the opposite is true.

For example, hedge fund billionaire Leon Cooperman recently suggested fair value is 17x EPS of $220, giving a target of 3740. Cooperman thinks 18 times $180 in earnings is appropriate in a recession, or 3240. Your calculus may differ, but this gives you an idea of how to quantify your thinking to create your stock market targets. Of course, don’t forget to adjust it as necessary if earnings outlooks or monetary policy (rates) change.

Ultimately, if the market remains range bound, as Kass believes, then calculating objective price points based on earnings and valuation will keep you honest and anti-" groupstink." 

Kass also offers an important reminder to avoid soundbite analysis. During earnings season, many try to get their take out faster than everybody else. This may win eyeballs, but it's unlikely to provide the deep-level context you'll need to make the best decisions with your money. 

Instead, wait until you read or listen to the conference call before investing your hard-earned capital. Remember, the initial action may be kneejerk trading by weak-handed traders rather than the start of a sustainable trend.

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