Kass: Two to Tango

This commentary originally appeared at 9:06 a.m. EST on Jan. 27 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

While I continue to expect some short-term market weakness, two important developments occurred over the past few days that will have a positive intermediate-term impact on the markets and on risk assets:

1. Mitt Romney has materially regained his lead in the Florida primary and the likelihood of him winning the Republican nod for presidential candidacy has measurably increased as well (based on this week's Intrade probabilities). A political regime change and Republican presidential win in November must be viewed, in the fullness of time, as market-friendly.
2. The Fed announced its intention to keep interest rates low into 2014. This will have a generally positive impact on equities but will have a mixed impact on financial stocks.

Regime Change

Let's first start with the Romney/Gingrich contest, remembering that a regime change in the November 2012 elections would be considered market-riendly and is an important precondition that I hold for the possibility that the S&P 500 regains new heights in 2012.

This morning's Wall Street Journal features a headline-grabbing poll conducted in tandem with NBC (below) that gives the impression that Gingrich is a clear leader over Romney. But when we read the fine print, we see that the poll was conducted days ago (Jan. 22-24) and only 441 Republican primary voters (a small sampling) responded. I totally dismiss the poll and question why The Wall Street Journal even published this old poll.

By contrast, below are the current Intrade probabilities (Jan. 27), which are more important to me and clearly show that Romney has resurfaced as a frontrunner for the Republican Party's nomination.

• Intrade has Romney's chances of winning the Florida primary at 91% vs. Gingrich's chances of winning the Florida primary at 8%.
• Intrade has Romney's chances of winning the Nevada caucus at 94.5% vs. Gingrich's chances of winning the Nevada caucus at 5%.
• Intrade has Romney's chances of winning the Republican nomination for presidential candidacy at 87.5%.
• Intrade has Obama's chances of being reelected at 54%.

I view the reestablishment of a large Romney lead as an important intermediate-term market positive.

Fed Policy Buoys Risk Assets, Hurts Some Financials

The second development -- that is, the Fed's announcement on Tuesday that interest rates will remain low into 2014 (and perhaps longer) -- while also a general market positive, will adversely impact certain sectors of the financial industry. If interest rates remain subdued, equities are now more valuable (in any discounted cash flow/earnings model).

That said, some areas of the financial sector (in particular) will be negatively impacted by Fed monetary policy, as net interest margins and low reinvestment rates will reduce many bank and insurance companies' earnings power and likely yield lower valuations and risk/reward ratios by threatening upside price targets.

Since I have been carrying a relatively large exposure to the general financial sector I have taken action and modestly reduced my exposure in discount brokers, banks -- I have decreased the size of my Financial Select Sector SPDR long -- and life insurance stocks (by hedging out a portion of my long positions by selling calls).

It is important to note that I don't think there is much downside risk to financial stocks but I do think upside targets have been reduced and (obviously) industry risk/reward has turned less favorable.

That said, some areas of the financial sector will benefit from lower interest rates in the form of improved capital market activity, continued low mortgage rates and a rotation out of bonds into stocks. These include private mortgage insurers such as MGIC Investment ; investment brokers such as Morgan Stanley and Goldman Sachs ; and asset managers such as T. Rowe Price , Legg Mason , Och-Ziff Capital Management and Waddell & Reed . I would be adding to these on any weakness.

Banks, in particular, including Citigroup , JPMorgan Chase and Wells Fargo , are negatively exposed to the Fed's Tuesday announcement of policy -- they have balance sheets that are net-asset-sensitive -- as non-trading income and net interest spreads will be compressed.

Life insurance companies such as Prudential , MetLife and Lincoln National face reinvestment issues that will mute profitability and upside price targets.

Discount brokers such as Schwab and E*Trade -- I will have more on the latter company's punk results later today -- and investment brokers such as Goldman Sachs and Morgan Stanley face a more mixed picture. While discount brokers' profitability and "earnings power" will be negatively impacted by low interest rates, in theory, a more healthy stock market will draw retail investors back into the market -- and I expect daily average revenue trades to improve at Schwab and E*Trade after a weak fourth quarter 2011. The major investment brokerage industry's future profitability has been enhanced by the likelihood of improving capital market activity and the probability that merger and acquisition volume will accelerate in the months ahead.

Bottom line: I believe that this week's two new developments -- namely, the improved prospects for a Romney presidential election win in November and lower interest rates -- will serve to limit the degree of market consolidation that I previously had expected in my opening missive on Monday and raise the probability that new highs in the S&P 500 will be achieved later in the year. At the same time, the prospects for lower interest rates will negatively impact certain financial companies. Net-net, I still expect a correction (though more shallow than previously thought) and a period of backing and filling ahead -- before a new bull market leg commences.