Doug Kass has a terrific track record of predicting the tops and bottoms of recent markets.  He has been known as a short seller the past several years as he thought the market over-valued.  Now, however, he has picked March 5, 2009 as the bottom and has gone long.  He was nearly alone in his convictions on that date, but has recently been joined by more and more investors, including yours truly.  Why does Kass think we have reached the bottom of this Bear?  Read on for more:

http://www.seabreezepartners.net/newsArticle.asp?id=449

March 24, 2009

Why the Bears Are Wrong
By Doug Kass, The Edge

I continue to believe that the early March low represented a yearly and, quite possibly, a generational market bottom.

The mustard seeds for the economy and the U.S. stock market have begun to take root.  The rate of change in 10 of 12 factors in my watch list are improving.

On Feb. 17, I presented a watch list of conditions that, if in an improving trend, would likely indicate that a sustainable up move is possible for equities.

It is time to review this checklist (and add one more factor) to determine the market's standing. Our new grades and those of two weeks ago are in parentheses and will be updated in the weeks and months ahead.

1. 1. Bank balance sheets must be recapitalized. Yesterday a comprehensive bank rescue package was introduced. It is obviously too early to consider its full impact, but the details of the program suggest to this observer that it will likely be effective in clearing toxic bank assets. (We grade the package a B+, up from a D+ only two weeks ago.)
   2. Bank lending must be restored. While bank lending standards remain tight, my view is that yesterday's announcement of ring-fencing toxic bank assets will almost unquestionably succeed in unclogging the transmission of credit. (Grade B, up from a C previously.)
   3. Financial stocks' performance must improve. Financial stocks have finally awakened from the dead, and the recent outsized move to the upside could foreshadow continued market strength. Historically strong relative performance in the shares of asset managers -- such as Franklin Resources (BEN), T. Rowe Price (TROW) and AllianceBernstein (AB) -- presage a better equity market, and Monday's strong group action was conspicuous in its outperformance. (Grade B+, up from a D.)
   4. Commodity prices must rise as a confirmation of worldwide economic growth. Beginning two weeks ago, commodities' prices began to strengthen, and the Fed's message last week accelerated that trend. Gold, copper (at the highest level since November) and crude oil (over $54 a barrel) continued to rise yesterday, reflecting a combination of continuing inflationary and currency debasement fears coupled with the possibility that worldwide economic growth might stabilize sooner than later. Finally, the TIPS market is forecasting some higher inflation, and a little inflation is better than a lot of deflation. (Grade B, up from a C+.)
   5. Credit spreads and credit availability must improve. Spreads remain worrisome and the transmission of credit remains poor, but the economy should gain traction as public policy is implemented, money is made more available and lending terms are liberalized. (Grade D, flat from two weeks ago).
   6. We need evidence of a bottom in the economy, housing markets and housing prices. As I have written, the retail industry has exhibited evidence of sequential improvement in the January through March period. Other economic signs are somewhat more ambiguous but, nevertheless, are showing some life. Months of inventory of unsold homes are declining and so are mortgage rates, but home prices have yet to stabilize despite an improvement in the affordability indices and a better relationship between home ownership and rental costs. Nevertheless, yesterday's strong existing homes sales release raises the specter of a better spring selling season than most anticipate. I contend that housing could surprise to the upside and might lead most other economic indicators higher. (Grade C+, up from a C-.)
   7. We need evidence of more favorable reactions to disappointing earnings and weak guidance. I am encouraged by the better price action in the face of poor earnings results and guidance in a wide range of companies, including Freeport-McMoRan Copper & Gold (FCX), FedEx (FDX), Airgas (ARG) and General Electric (GE). (Grade B+, up from a C+.)
   8. Emerging markets must improve. China's economy (PMI and retail sales) and the performance of its year-to-date stock market have turned decidedly more constructive, but other emerging markets remain moribund. (Grade B up from a C.)
   9. Market volatility must decline. The world's stock markets remain more volatile than a Mexican jumping bean. (Grade C+, flat with two weeks ago.)
   10. Hedge fund and mutual fund redemptions must ease. I am comfortable writing that the worst of the redemptions are behind the asset management industry. Nevertheless, the disintermediation and disarray in the hedge fund and fund of fund industries still have a ways to go. And while brokerage account liquidations appeared to have decelerated last week (coincident with rising share prices), my high net worth brokerage contacts (such as Baron Von Broker) continue to experience account closures and a panicked constituency. (Grade C, up from a D).
   11. Marginal buyers must emerge. Low invested positions at hedge funds and by individual investors no doubt fueled March's market rise as the fear of being out has begun to replace the fear of being in. These two classes could continue to be the near-term marginal buyers fueling stocks. Corporate acquirers could also emerge as important marginal buyers, and the recent step up in merger and acquisition activity -- for example, Genentech (DNA), Petro-Canada (PCZ), Schering-Plough (SGP) and Daimler (DAI) -- is a concrete indicator that another important marginal buyer has surfaced. As the year progresses, a meaningful upside move awaits a broad asset allocation move of pension funds out of fixed income and into equities. (Grade B, up from a C.) To the above factors, I am adding a 12 factor in my watch list:
   12. The market's internals must improve. I am comforted by a number of improving technical conditions that have emerged since the March low and that have continued in force over the past two weeks since the market has made program off that nadir. Indeed, the conditions of the recent low were different than others -- in sentiment, volume, number of new lows and in intensity. The move from the October lows to the March lows indicated growing fear and gave way to rising cash positions and the loss of hope, but the market's internals were improving. November's DJIA low of 7,552 was nearly 11% below the October low of 8,451, and the March low of 6,547 was 22.5% under October's low. While each new low was more frightening than the prior one, however, there were improving technical and sentiment signals. For example, NYSE volume at the October low expanded to 2.85 billion shares; at the November low, volume dropped to 2.23 billion shares; and at the March low, volume was only 1.56 billion shares. As well, new lows traced decreasing levels: At the October low, there were 2,900 new lows; at the November low, there were 1,515 lows; and at the March low, there were only 855 new lows on the NYSE. Moreover, the combination of last Tuesday's 12:1 ratio of advancing stocks over declining stocks coupled with that day's 27:1 up-to-down volume ratio has not occurred in almost 65 years. Remarkably, yesterday was the fifth 90% upside day in March, which is evidence of a broadening market.

In summary, 10 out of 12 factors (including our newest, market internals) on my watch list are in an improving mode. Though many variables are currently accorded relatively low grades and the outlook remains debatable, the delta (rate of change) in almost my entire watch list is improving and flashing a green light for the U.S. stock market.

A classical wall of worry is being reinforced by an overwhelming consensus that the recent advance was a bear market rally. Moreover, the negative "chatter," as Jim "El Capitan" Cramer describes it, appears loosely constructed and fails to credibly argue against the salutary effect that $4 trillion of stimulus will have on the domestic economy.

Based on the 12 considerations comprising my watch list, I respectfully disagree with the prevailing negative consensus, most of whose members failed to properly analyze the cracks in the foundation of credit, in the economy and in equities two years ago. Indeed, it remains my view that the fear of further investment losses and possible investor redemptions are clouding many managers' objectivity in assessing the markets.

In the fullness of time, public policy aimed at stimulating the economy (in general) and in housing (in particular) should bear fruit, as will the ring-fencing of toxic bank assets serve to unclog the transmission of credit.

While it is unrealistic to expect a straight up move, I am growing increasingly confident in my variant and optimistic view that the early March low was not only a yearly low but, quite possibly, a generational low.

Coming Monday, March 30:  Jeremy Grantham 1st Quarter Commentary

Brian McMorris

* Age: 52
* Industry: Engineering - Automation and Industrial Robotics
* Occupation: Business Development
* Location: MN : United States

I have a broad range of interests in technology, engineering, design, finance and public policy; a BSBA degree in International Marketing from Arizona State University with undergraduate studies in Nuclear Engineering and Architecture from Oregon State University; I have more than 30 years experience in instrumentation and control design and product development.

I have spent some time during recent days in remorse. "How did I not see all of this coming and get into cash?", I ask myself. But I am being unfair to myself, because I did see all of this coming, but could not bring myself to believe that it would actually happen or pull the trigger to sell out and get 100% into cash.

I looked to see what I was saying in January 2004, and low and behold, I thought all of this was a possibility, though in early 2004 I did not yet fully appreciate how much the real estate bubble would affect the future. By the end of 2005, I understood that was the true danger. But if our financial system was not so inherently weak prior to that bubble, it would not have brought the system down. Looking back on this advice, it sounds as relevant today, as it did almost five years ago.

Here is what I said in my annual letter, January 2004:

REAL ASSETS

This category was not mentioned in previous reports, but is an area of great interest. The base materials (natural resources) markets have outperformed many equities and all bonds in 2003. Gold, like oil and other natural resources, has reversed a 25 year downtrend. This is very significant. It was only two years ago that many central banks decided to liquidate gold reserves, pressuring prices with the anticipation of increased supplies. Now, gold has gone from $250, to well over $400/oz. in 18 months. What does this mean? Is it a portent of things to come? Gold has been the “Anti-dollar” since 1971, when the USA (and by extension, any central bank with currency linked to the dollar) went off the gold standard and onto a paper based standard (the USD). Gold prices went from $35 in 1971 and eventually to $850 in 1980, during the height of inflation. Then as now, gold strengthens when the dollar (and other paper currency) weakens, as gold is the alternate form of world financial exchange.

Gold and other commodity prices are considered by many economists to be predictors of future inflation. Inflation is created by excess debt leading to declining currency valuation. If government and consumer debt and money supply is again in excess, then inflation and declining purchase power of the USD is on the way (Boy, sure got this one right!!). The deficit spending of the past 3 years rivals the late 60s, during Johnson’s “Guns and Butter” program, as a percent of GNP. But the story is really worse this time. Unlike the 60s, when the USA was still the world’s creditor nation coming out of World War 2, with positive balance of trade, now, the USA has severely negative balance of trade. Continued build up of national and personal debt is doubly troublesome. Unlike the 1970s, now have nothing to offset our debt, except more paper.

Potential “Doomsday” scenarios come out of this ominous situation. At best, as hoped for by me, the large national debt will result in a price inflation, a stagnant economy, flat stock market, and declining bond prices in concert with increasing interest rates. See the 1970s for an example. I believe this is what the Fed is now trying to engineer: dollar devaluation and price inflation. The dollar devaluation makes exports more attractive and imports less attractive, helping our trade balance. Price inflation reduces the impact of long-term debt for both government and consumer at the expense of the creditors: mortgage holders in the case of consumer debt and foreigners in the case of government Treasury bonds.

In the worst case scenario, the dollar’s value will disintegrate taking the USA and many other dollar-denominated economies with, leading to a global financial crisis and depression that could last for 10 or more years. From this depression will emerge a new global financial power, China, which would de-link its currency from the USD, and make the China Yuan as the new global currency standard. As the new creditor power, replacing the USA role from the 50s and 60s, China will dictate world policy.

The end result of these concerns is the need to own either commodities in the form of mining, energy or other natural resource companies, and rare metals: gold, silver, platinum, etc, in certificate or in fact.

Energy stocks are another commodity that would do well in an international financial crisis. Asia (China) continues to increase consumption of energy products, like oil and coal. Supply is limited and requires years of effort to expand. Commodities will also do well during a period of global inflation, or deflation, as during the 30s. Raw material values may not increase in absolute terms during periods of deflation, but they do not decrease much, either. So, if currencies increase in value, as they do during a period of deflation, then commodities appreciate in relative terms.

This is just my speculation, but I wonder if this chaos is being initiated by Islamic extremists. There is enough money from oil sales in the hands of Iran or other anti-American oil nations to precipitate this crash.

Think about it: the entire goal of hitting the WTC on 9/11 was to collapse the Western world's financial system. Knocking down buildings didn't work, so I am sure Al Queda and other extremists went to work on a new plan to do the same.

There was evidence of short selling by Islamists against the American market on the days leading up to 9/11. They know how to use that tool. To make the case more compelling was the attack on the US Embassy in Yemen yesterday. Al Queda likes to conduct attacks on multiple fronts to undermine confidence in the Western economic system.

Today, I just heard that there is a short selling campaign against State Street Bank, which is a major clearing house for Wall Street, based in Boston.
If this is the case, it can be stopped by a concerted effort of the Central Banks and regulators. The terrorists know that we are very reluctant in a free economy to employ controls. They are counting on us allowing our free markets to solve the problem. But they are manipulating short selling against major banks, one at a time, first the weak, and then the strong. We should be suspending all short sales, period, against money center banks and major financial institutions. That will freeze the market, but at least it will get rid of the speculation.

Then, there should be an intense effort to trace every significant short sale against banks on record to trace back the transaction to its source. If those sources are foreign, the accounts that transacted the business should be frozen. If we find it is terrorists, we should do everything possible to eliminate those people. If the transactions are domestic, the FBI should be sent to question the transactors to find out their intentions. If the intentions are found to be manipulative rather than speculation, the transactors should be prosecuted on federal racketeering charges.

This is what I hope is happening today behind the scenes.

On Friday, at the market close, and less than 6 hours after the Financial stocks tanked on the bad employment data from August, Treasury Chairman Hank Paulsen let leak that the Feds would be taking over Fannie and Freddie on Sunday.

My reaction was: DARN! or something close to that. I had been waiting for this to happen and knew it would create a trading opportunity on the financial indexes that I have been trading. But unlike the Bear Stearns bailout in March, where the rumor was on the net a couple days before the event, this one was very well guarded. Some people must have known as after the financials tanked Friday, they worked their way higher all day from about 10am on. Then, at the close, when the press release about the meeting on Sunday was announced, the UYG popped by 10% and I knew my goose was cooked, at least for a few days.

I would have loved to have been on the right side of this trade, but the financials had not dropped enough for me to cover my short position (SKF) and take a new long position (UYG). I was close, but about 5% away from pulling the trigger. And, as I have a day job, I did not have a chance to watch the financials move higher all day long into the close and the Fed press release. Had I been a full time trader, I would have looked into that counter trend movement (against the backdrop of the bad employment data in the morning) and might have found enough information to get me to switch direction.

But all is not lost! This is NOT the proverbial "other shoe dropping" signaling a change in direction for the financials, the stock market and the economy. In fact, I was stunned that the market reaction was so dramatic this morning. The fact that the Fed would have to intervene in Fannie and Freddie has been known for many weeks, really since the July 15 bottom when Paulson asked for and received authority to make this move. Most market followers expected this move sooner than this, so there should have been no "surprise factor" here.

In fact, the deal went down just about as expected. Fannie and Freddie common share is basically wiped out. This was necessary to eliminate concern of "moral hazard" where investors get taken off the hook by taxpayers. But Paulsen did not stop at common shares, he also took out the preferred shareholders. He did not actually bankrupt the company, but by giving warrants to the US government / taxpayers that give 80% of the equity to the government, with no dividends until Fannie and Freddie get profitable, for practical purposes, the stock is worth very near zero.

Worse for the financial market, many banks hold Fannie and Freddie preferreds as part of their capital structure. This was an arrangement with the bank regulators where FNM and FRE stock was considered as safe as cash, so avaiable as collateral for capital. But, it was not so safe and has now been written down to nothing. In fact, the preferred was not convertible to common, so its only value is for the dividend, which has now been eliminated for the forseeable future.

This is a material surprise. And it has a materially negative impact on many banks. That information will get back into the stock price in the next few days. I still think the Financials will continue to go down, with bounces along the way. I would use this opportunity to get short on Financials, which I am doing by selling more puts on SKF.