25 Surprises for 2007 By Doug Kass 25 Possible Surprises in 2007 1. Private-equity deals begin the year in a spectacular fashion, with two separate $50 billion acquisitions in January. A consortium of Silver Lake Partners, The Blackstone Group, Kohlberg Kravis Roberts, Texas Pacific, Bain Capital and Goldman Sachs (GS) acquire Texas Instruments (TXN) . Kohlberg Kravis Roberts leads a syndicate in the takeover of Caterpillar (CAT) , the 55th largest company in the S&P 500. Later in the month, one of the largest buyouts in the history of the media and entertainment industry is made by Bain Capital and Thomas H. Lee Partners when they acquire CBS (CBS) for $30 billion. In early February, Goldman Sachs (teaming up with Warren Buffett's Berkshire Hathaway (BRKA) ) announces that it is considering a going-private transaction. The Goldman deal is abandoned three months later, as a fractured mortgage market leads to a standstill in deal-making as the capital markets (and underwriting activity) seize up. 2. Robert E. Rubin returns to his brokerage roots and becomes the CEO and chairman of Salomon Brothers/Smith Barney after Citigroup (C) decides to break up into three separate companies: a domestic money-center bank (Citibank), an investment banking/retail brokerage (Salomon Brothers/Smith Barney) and an international consumer finance company (Citiglobal). 3. Based on misleading government statistics, the housing market appears to stabilize in the first quarter of 2007. For a few months, those forecasting a bottom in residential real estate appear vindicated. Evidence of cracks in subprime credits are ignored, with housing-related equities soaring to new 52-week highs by March 1. 4. However, continued heavy cancellations of home contracts -- which are included in the government releases on homes sold and lead to an erroneous inventory of unsold units for sale -- lead to: A dumping of homes on the market in the spring A quantum increase in the months of unsold housing inventory A dramatic drop in the average home selling price. Sales of existing and new homes take another sharp leg lower as we enter what I've dubbed "The Great Housing Depression of 2007." Importantly, the financial intermediaries that source mortgage financing/origination begin to feel the financial brunt of "The Great Mortgage Bubble of 2000-06" after years of creative but nonsensical, low or nondocumented lending behavior. 5. Foreclosures steadily rise over the course of the year to nearly 3 million homes in 2007 vs. about 1.2 million in 2006. Deep cracks in the subprime market spread to other credits in the asset-backed securities market as a lumpy and uneven period of domestic economic growth takes its toll. In a similarly abrupt and dramatic manner, credit spreads fly open and revert back to mean valuations, as previously nonchalant investors are awakened to the reality of credit risk. 6. The magnitude of the credit problems in mortgages takes its toll on the hedge fund industry, which is much more exposed to real estate than generally recognized. A handful of multibillion-dollar, derivative-playing hedge funds bite the dust in the aftermath of the housing debacle. Several California-based industrial banks fail (the West Coast is always at the leading edge of financial creativity and leverage!), and a large brokerage firm, heavily involved in fixed-income market-making and trading, faces material losses, and its debt ratings are downgraded. As the financial contagion spreads, rumors of a $10 billion-plus derivative loss at JPMorgan Chase (JPM) (which ultimately prove to be false) spark the largest one-day percentage drop in its shares in the past 15 years. 7. In a panic, Congress announces a series of hearings on the derivative industry, and the Federal Reserve reduces the fed funds rate by 50 basis points in each of three consecutive meetings. Those efforts are too late to affect the already weakening economy as the long tail of housing begins to affect not only consumer confidence and spending but also other peripheral areas of the economy. 8. Commodity prices begin to collapse even before the mortgage market fiasco, but the onset of the decline is initially ignored by stock market investors. The CRB Index moves below 300. Notably, crude oil falls under $50 in a deflationary scare as interest rate cuts fail to revive the economy. The yield on the 10-year U.S. note falls to below 4% and stays there over the balance of the year.
9. Corporate profits for 2007 end up virtually flat year over year, but the pattern is inconsistent. After rising 8% in first-quarter 2007, corporate profits are down 5% in second-quarter 2007, up by 2% in third-quarter 2007 and back down by 4% in fourth-quarter 2007. 10. Equity-market volatility, like credit spreads, rises exponentially. The S&P 500 routinely has 2% daily moves, acting more like a commodity than a stock index. Mutual fund and hedge fund redemptions rise dramatically. 11. Stocks begin 2007 the way they ended 2006 -- very strong -- and the S&P 500 temporarily breaches 1450 in February. But by the end of the second quarter, under the brunt of the mortgage implosion, stocks drop nearly 15% and remain relatively range-bound for the rest of the year. The S&P 500 ends the year at around 1250, dropping by about 11% in 2007. Reflecting the deflationary threats, one of the best-performing groups of 2006, industrial materials, morphs into the worst-performing group in 2007. With credit spreads flying open, the junk-bond market records its worst performance in over two decades and substantially underperforms almost every asset class in 2007. Technology, pinched by an abrupt demand plunge in consumer electronics, a listless response to Microsoft's (MSFT) Vista and a drop in business spending, ends the year with a 20% decline in value. 12. Fidelity Management announces the introduction of its first dedicated short equity product. Alliance Capital follows with a similar product shortly thereafter. 13. With confidence in the markets and economies ebbing, merger-and-acquisition activity slows to a crawl by May. Several leading universities and endowments, which previously underwrote large private equity commitments, announce that they are dramatically reducing their exposure to that asset class. As the capital markets falter, institutional funds committed to real estate are also reined in, initially leading to a marked slowdown in the recent appreciation in office building values. While broadening economic weakness leads to only a slight rise in office vacancy rates, as the year progresses vacancy rates deteriorate more noticeably. REIT shares get hit hard (and fall below net asset values) as the historic relationship between REIT dividend yields and the yield on the 10-year U.S. note mean regresses. 14. A well-known corporate raider finds himself with a concentrated portfolio of illiquid investments and suffers large losses. ESL's Ed Lampert cagily watches the early-year private-equity euphoria and does nothing, opting to shore up his liquidity. But as equity prices drop in the second half, he is joined by several previous corporate partners in making a large acquisition in the entertainment/media field by year-end. 15. America's growing dependency on convergence and connectivity (computers control power delivery, communications, aviation and financial services) becomes a battleground and launching pad for a series of cyberterrorism acts by a terrorist group in early 2007. The first few virtual attacks are ignored and have no effect on the market or on the Internet. However, during a chaotic weeklong period after the July Fourth holiday, an attack renders the Internet partially ineffective, threatening to eradicate crucial information storage bases and to stop commerce and communication. 16. There are several political surprises in 2007. Most significant is that New York Sen. Hillary Clinton, citing personal issues, announces that she will not run for the Democratic presidential nomination in 2008 and that she will throw her support to former Vice President Al Gore's candidacy. Democratic hopefuls Barack Obama, John Kerry, Evan Bayh and Joe Biden do not pursue the nomination, leaving Senator John Edwards as Gore's only viable competition. On the other side of the ledger, Newt Gingrich is an early aspirant to the Republican nomination and, surprisingly, is in a dead heat in early polls against the favorite, Sen. John McCain, with Mitt Romney and Condoleezza Rice far behind. Rudy Giuliani does not enter the race after a New York Times investigative report uncovers some questionable business dealings.
17. After New York Yankee baseball team owner George Steinbrenner falls seriously ill, SAC Capital Partners' legendary Steve Cohen acquires a majority control of the New York Yankees and, at year-end, retires from active management at his hedge fund. 18. Wal-Mart (WMT) fails to come out of its funk and reports five consecutive months of negative same-store sales. Overall retail spending follows the housing decline and briefly falls to levels that haven't been seen since the last recession as consumer confidence drops to lows not seen in more than 15 years. Purchases of discretionary items such as motorcycles, high-end kitchen appliances and jewelry suffer. 19. Google (GOOG) marches on, proving its skeptics wrong, and dramatically exceeds sales, profit and cash-flow expectations. Its shares approach the $650 level by early spring, after rising by more than $100 the day after first-quarter earnings are announced. Though results continue to beat expectations in the second and third quarters, the shares take a large hit after its domination and monopolistic position in search is questioned by legislators in a series of congressional hearings later in the year. 20. Saddam Hussein is assassinated in jail even before his appeal is concluded. Osama Bin Laden is found dead, and initial reports indicate he has been dead for more than 12 months. 21. A series of corruption scandals in Russia hits the emerging markets in 2007, which further exacerbates the impact of uneven worldwide economic conditions and difficulties in the mortgage markets. 22. A large hedge fund lowers its investment management fees (to 0.5%) and incentive fees (to 10%). This effort, combined with the overall market weakness in 2007, leads to a 50% reduction in the number of hedge funds over the next 12 months. 23. With the hedge fund ranks diminished, commodities dropping in value and the appeal for alternative investments (private equity, real estate, etc.) moderating, the bullish chorus for a global liquidity case for equities becomes a faint whisper. 24. Maria Bartiromo leaves CNBC to join Joy Behar, Rosie O'Donnell and Barbara Walters on ABC's "The View." (At the same time, Elisabeth Hasselbeck gets booted off the show!) Another well-known CNBC anchor leaves to join a large hedge fund. 25. Amid the early 2007 stock market euphoria, Jim "El Capitan" Cramer's "Mad Money" show goes prime time on CBS. But it is canceled during the midyear market meltdown and returns to CNBC by the fall. CNBC extends the show to two hours by year-end after Cramer, The Movie reaps $38 million in its first weekend.
Here's surprise #26 Interest rates make a big upturn...and the deflation scare turns into stagflation.
If this guy is close to correct, 2007 will be a great trading year....unfortuneatly for a better trading environment, we need stuff like this to happen....not pretty....but true....
25 Takes on Kass' Surprises for 2007, Part 1 By James Altucher I have to say again that Doug Kass is bold for putting out his 25 Surprises for 2007, parts 1 and 2. All I can do is comment on them rather than go out on a limb like he did. I do think his stab at attaining "prophet" status is both thought-provoking and a little "did he really say that?" but his ideas are great jumping-off points worth following up on. Here are my thoughts on his 25 -- and I look forward to any email or Columnist Conversation responses they provoke. 1. Private equity deals. Kass gets into specifics about the private-equity transactions he believes will happen in the beginning of the year, including ones with Kohlberg Kravis Roberts, Goldman Sachs (GS) and Berkshire Hathaway (BRK.A) . I agree with his general sentiment, that 2007 is going to be the year of private equity. There is so much cash out there, it's ridiculous, and the shameful secret every private-equity firm carries is that its management fees begin to go away if it doesn't spend the money. They're all time bombs of massive leveraged buyouts waiting to happen. Doug's specific call that Goldman is going to go private definitely won't happen, though, particularly with Warren Buffett behind it. 2. Citigroup changes. I found this item very stimulating: Kass says that Bob Rubin, former Goldman Sachs chief and Treasury secretary under President Clinton, will become CEO of Salomon Brothers if ("when," as Kass says) Citi decides to spin it off. I believe there's zero chance of this, but with so many people calling for Chuck Prince's head, I wouldn't be surprised to see Rubin, currently Citi's chairman, become CEO as well. 3. Stabilizing housing. Kass says: "Based on misleading government statistics, the housing market appears to stabilize in the first quarter of 2007." With interest rates so low and prices in many areas already plunging, why wouldn't the housing market stabilize? I agree with his conclusions, but without the conspiracy theory. 4. "The Great Housing Depression of 2007." I just don't see it, not with 4.5% rates on 10-year yields and short-term interest rates getting cut at any sign of a more severe downturn in housing. Although, that said, I do somewhat agree with No. 5. 5. "Foreclosures steadily rise." I do believe that the subprime, BBB-rated category of homeowners is in trouble. These are people who have never been granted loans before and now they're getting mortgages at almost the same rate a herd of Bob Rubins would get them. However, these also are exactly the sort of people who don't have a huge effect on the economy one way or the other when they abandon their homes. Kass says that the asset-backed securities, or ABS, market will be fractured by the volume of foreclosures at the subprime level. I've spent some time doing due diligence on very smart funds on both sides of this trade. I have no idea who is right(Nobel-level economists were doing the modeling on each side, so who am I to argue?). However, if the ABS market does start to fracture, enough hedge funds and banks are short the subprime tranche that a short squeeze would buffer any fall. 6. and 7. The hedge fund and derivatives industries. These are scary "surprises" worth pondering. If the subprime market falls apart, banks such as JPMorgan Chase (JPM) could be exposed to trillions of dollars in counterparty risk. This is a doomsday scenario, and I know at least one multibillion-dollar hedge fund that told me it has taken out credit insurance on JPMorgan as a bet that this actually will happen. But there's a reason this type of insurance trades for pennies on the dollar: Most people believe this doomsday scenario is extremely unlikely. I'm in that camp.
8. Commodities. Kass says they'll collapse, and I agree that commodities will go down like they always do. Check out my column on the Madagascar Vanilla market to learn why. 9. Flat corporate profits. I just don't see how this is possible, given the extreme dollars that are going to be spewing at Microsoft (MSFT) because of Vista and Exxon Mobil (XOM) because oil is nonstop, and Google (GOOG) because online advertising is going up another $6 billion and it'll be the main beneficiary -- just to name a few. But this is a hard thing to model out with precision, and almost everyone I spoke to at the beginning of 2006 (you know who you are) was wrong about where we would be now in terms of corporate earnings. 10. Volatility rises exponentially. This one really interests me because the reality is, volatility confuses me. It's usually measured by the VIX indicator. In the 10 years I've been trading, the VIX has never been even remotely as low as it has been this year. And right now, this second, it's basically at an all-time low, or near it: [VIX chart] Historically, this has been a mean-reverting indicator; in other words, when the VIX very high when compared with historical averages, it invariably comes down (as in 2001 and 2002) and when it's very low, it invariably goes higher. Very roughly, without going through the math on this, the VIX being at 10 right now means investors are assuming the markets are going to be almost flat over the next year with a very tiny range throughout the year. This is almost certainly false; I agree with Kass that volatility will go up. We could even experience massive corrections along the way, since an increase in the VIX is usually associated with a decline in the market. However, the VIX is so low that I don't know if we can really use any historical results to make a prediction here. After all, the markets and the VIX rose in tandem from 1995-99. And now more than ever before, hedge funds that use put-selling strategies have flooded billions into how this indicator is calculated, artificially lowering it. The VIX could go up, but I don't necessarily know if this will cause panic in the markets. 11. The arc of the markets. Kass believes the markets will begin 2007 very strong. I agree. But then he predicts that the S&P will end the year around 1250, dropping 11% in 2007. Certainly a correction can happen. But the global economy right now is flourishing; interest rates are low, continuing to have their stimulus effect; and price-to-earnings ratios relative to interest rates are near all-time lows. Historically, the earnings yield of the S&P 500 (earnings over price; about 6% projected for 2007) has almost always been lower than the yields on T-bills. Now it's greater. The market is pretty much backing in almost permanent zero or less growth in the economy. I believe that when people realize this is not happening, the S&P 500 will spike incredibly in 2007. In particular, Kass believes tech will fall by 20% in 2007. Didn't this already happen just a few years ago? Again, short-term corrections can happen. But Vista is going to light things on fire at some point in 2007. 12. Fidelity and Alliance announce dedicated short products. I'm sure this is top of mind for Kass because his product is a hedge fund-dedicated short product. But Doug, don't worry so much. Try to enjoy life a little! 13. M&A activity will begin to slow down. With private-equity firms flush with cash and S&P 500 companies sitting on $600 billion in cash, I just don't see this happening. Editor's note: Check back for Part 2 of this column Monday.