It's been quite a rally.
After stocks were deeply oversold in early April following what President Donald Trump called his Liberation Day tariff reveal, the S&P 500 has posted rip-roaring returns, gaining 20% in about six weeks.
The rally caught many investors off guard. The potential for tariffs to increase inflation, zapping economic activity and corporate profitability, had sent stocks down 19%, just shy of bear-market territory.
One investor who wasn't surprised was the Wall Street veteran hedge fund manager Doug Kass.
Kass has been investing professionally since the early 1970s. His career, which includes a stint as research director for billionaire Leon Cooperman's Omega Advisors, has enabled him to make several savvy calls, including forecasting the bull market top in 2021 and bear market low in 2022.
More recently, Kass correctly predicted a stock market reckoning this year in December and accurately called for the S&P 500 to bottom after its tariff-driven selloff in April.
Kass updated his view on stocks this week, and his latest thoughts may frustrate some investors.
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The economy is sputtering but stocks don't care
The US economy has slowed markedly from its pace last summer, and that should be bad news for the S&P 500, given corporate revenue and profit growth are cornerstones of stock market valuation.
The economy's headwinds include shifts in consumer spending toward essentials from discretionary buys amid sticky inflation; a weak jobs market, and eroded consumer and business confidence.
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The uncertainty associated with stiff tariffs and mounting US debt adds to the pressures.
In short, the backdrop isn't nearly as favorable as it was for stocks in 2023 and 2024, when optimism that the Federal Reserve would shift from hawkish to dovish monetary policy and growth in spending on artificial intelligence fueled back-to-back 20%-plus returns for the S&P 500.
Inflation has retreated since it peaked above 8% in 2022. However, core inflation remains above the Fed's 2% target. The latest core Consumer Price Index and Personal Consumption Expenditures data show inflation at 2.8% and 2.5% in April, respectively.
Meanwhile, the Fed's rate cuts last September, November and December have yet to reverse recent job losses. The unemployment rate has increased to 4.2% from 3.4% in 2023. According to Challenger, Gray & Christmas, companies have announced over 602,000 layoffs this year, up 87% from last year.
Given inflation and jobs data, it's little wonder consumers feel uneasy, especially amid a turbulent sea of trade war news.
The Conference Board's Expectations Index improved last month on hopes of China trade negotiations, but at 72.8 it remains below the 80 threshold commonly found ahead of a recession.
Despite all the challenges, the stock market has marched higher since April 9, when President Trump reversed course and paused many of the reciprocal tariffs announced on April 2.
However, 25% tariffs remain on Canada, Mexico and autos, and a 30% tariff on China (down from 145% previously). The recent decision by the Court of International Trade blocking most of Trump's tariffs is primarily seen as temporary, with plenty of levers available to the White House to continue its trade war. (In fact, a federal appeals court has delayed the trade court's block on the tariffs as it considers the case.)
Yet the stock market has largely shrugged, with the S&P 500 returning 20% from its April 8 low, including a month-to-date 6% return in May.
Fund manager issues dire warning on stock market amid sky-high valuation
In December, Kass correctly forecast that stocks had run too fast and that the S&P 500 was due for a pullback of 15%.
Initially, Kass was wrong, as the S&P 500 rallied into mid-February. But he continued to beat the bearish drum, a savvy move given the S&P 500's 19% slide through early April.
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The stock market's drop was rapid and steep, prompting Kass to correctly pivot to bullish in April, citing the likelihood of an oversold rally.
Now that we've received those expected gains, Kass has shifted again, taking a decidedly bearish tone.
“I am respectful of the market's extraordinary price momentum over such a short-term time frame; however, I plan to put a larger short stake in the ground,” wrote Kass in a post on TheStreet Pro. “Going against the consensus grain and the herd is nothing new to me.”
Kass's bearishness is rooted in the rise of global economic uncertainty and the potential threat to the concept of American exceptionalism.
“Political and geopolitical polarization and competition will probably translate into less centrism and, in turn, a reduced concern for deficits,” wrote Kass. “This will create structural uncertainties, fiscal sloppiness, and worldwide imprudence. It will also create the possibility that bond markets ‘disanchor.'”
Kass says valuation has once again become frothy, given that the forward price-to-earnings multiple is back above 21, according to FactSet. That elevated p/e multiple is problematic if the economy suffers stubborn inflation and slow growth.
“I, however, still see valuations and consensus expectations for economic and corporate profit growth inflated,” wrote Kass. “So, look for the soft data to weaken into the hard data as the housing market slows and the vulnerability of the middle class is revealed. Expect below trend-line economic growth with sticky inflation lie ahead (“slugflation”).”
How far could the S&P 500 drop if things worsen?
“I view less than 5% upside compared to 10%-15% downside. This is an increasingly unattractive ratio of nearly three to one,” said Kass.
Related: Fed official sends strong message about interest-rate cuts
