Swimming downstream is a lot easier than upstream. The same holds for investors in the stock market. Picking winners is much simpler when momentum is taking stocks higher.Â
However, following the herd isn’t always best when investing your hard-earned money. Otherwise, you risk running right over the cliff.
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And that’s what has happened since mid-February’s all-time highs on the S&P 500. The benchmark index has faced a reckoning that lopped nearly 6% off its value, including a 3% tumble this week.Â
The retreat has surprised many, but veteran hedge fund manager Doug Kass isn’t among them.
Kass, who has managed money professionally for nearly 50 years, correctly warned of a pending stock market drop in December and continued raising a red flag over the risk in January and early February.Â
Related: Veteran fund manager unveils eye-popping S&P 500 forecast
It’s not the first time Kass has been right by taking the other side of the trade. He correctly predicted that surging inflation would derail stocks in 2022 and that stocks would rally in 2023.Â
Of course, nobody is perfect, including Kass. Still, his deep experience managing money professionally, including as director of research for Leon Cooperman’s Omega Advisors, and his prescient past calls suggest investors should pay attention to what he thinks about the S&P 500 after its retreat.
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The stock market hits a rough patch
The S&P 500 delivered an eye-popping 24% return in 2024, more than twice the average annual return of about 10% since 1957.
The rally was built upon three major themes: a friendly Federal Reserve, surging spending on artificial intelligence, and Goldilocks economic growth.
Related: Every major Wall Street analyst’s S&P 500 forecast for 2025
A good argument can be made that those tailwinds have faded.
The Fed’s dovish monetary policy followed the most hawkish rate increases since Paul Volcker broke inflation in the early 1980s. After the Fed wrestled inflation down from its peak above 8% in 2022, steady declines in the front half of 2024 led many market players to model for rate cuts to shore up what was becoming an unsteady jobs market.
Fed Chairman Jerome Powell cut rates in September, November and December 2024, fueling animal spirits and bets for more cuts this year. Inflation has since rebounded, however, rising to 3% in January from 2.4% in September, according to the Consumer Price Index.
As a result, the friendly Fed argument is no longer a given. Powell paused interest rate cuts in January, and most think the odds of more cuts anytime soon are low.Â
Cracks in the AI-spending argument have appeared as well. Undeniably, companies’ capital expenditures have soared to train and operate AI chatbots and agentic AI solutions. But worry is mounting that spending growth could reset later this year following the la`unch of DeepSeek and due to a weaker economy.Â
DeepSeek is a Chinese large-language AI model that competes with OpenAI’s ChatGPT, Google’s Gemini and Microsoft’s Co-Pilot. If you believe the DeepSeek company, it cost only $6 million to create. It claims it uses prior-generation computers and semiconductor chips, rather than pricey next-generation solutions offered by Nvidia, such as its popular H200 chip, which is restricted for sale in China.
Finally, the economy seems to be losing its balance. There’s been a steady cadence of layoffs, including in the previously hot market for technology workers. Big technology companies have cut about 407,000 jobs since 2022, according to Challenger, Gray, & Christmas’s January report.
The unemployment rate has inched up to 4% from a low of 3.5% as recently as 2023, and unemployment-benefits claims last week surged to 242,000 from 203,000 earlier this year.Â
Economic uncertainty has also recently been fueled by tariff talk following the White House’s decision to slap 25% tariffs on Mexico and Canada and double China tariffs to 20%.
Many economists, including former Treasury Secretary Robert Rubin, suggest that tariffs could increase inflation and slow the economy by crimping productivity.
Fund manager updates stock market warning after tumble
The stock market retreat isn’t lost on Kass. Unfortunately, his renewed forecast isn’t very reassuring.
Related: Goldman Sachs CEO has 2-word response to recession talk
Through Tuesday, the Magnificent 7 tech companies were 10% lower year-to-date “or double the decline of the Nasdaq Index and compared to only a couple of percentage drop in the S&P 500 Index,” wrote Kass in his trading diary on TheStreet Pro.Â
“The expected downturn will not likely come in a straight line. It is my view that machines and algos will exaggerate moves up and down, contributing to a sawtooth pattern lower.”
Kass expects short-term relief rallies, such as the strong intraday rally witnessed on Tuesday afternoon, but he says those rallies will fail and stocks will wind up with lower highs and lows.
“I do not expect the recovery in stocks (seen in the last 12 hours) to be long-lasting or the start of another leg in the bull market that we have witnessed over the last two years,” said Kass. “I believe the market is on a path for a 10-15% decline this year.”
The reasons cited for his downbeat view: slugflation (sticky inflation and low GDP growth), the Fed’s pause on interest rate cuts, stock valuation (the S&P 500’s forward price-to-earnings multiple entered this week above 21, higher than the 10-year average of 18), and the tariffs.
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“I am fearful that the lack of predictability of current economic (and tariff) policy, in and of itself, may contribute to delayed capital and consumer spending — and even slower economic growth than I currently anticipate,” added Kass.
So, how should investors react? Stocks go up over time, but they don’t do it in a straight line. On average, markets see a 5% or more drop about once yearly, according to Capital Group, a fund manager with more than $2.7 trillion in assets. That suggests long-term investors might not want to make any drastic decisions.
Active investors, especially those who borrowed money to buy stocks on margin and day traders, may want to temper their optimism. Sometimes, taking risks can be dumb, as billionaire 5-hour Energy Founder Manoj Bhargava recently pointed out.
