Kass: Blinded by the Derivatives Boom

While the market has dismissed my warnings -- most of which have come, or are coming, to pass -- I suspect that tolerance as well as the unquestioned momentum stimulated by the strength (or madness) of crowds are eroding. Today there are a number of obvious problems/casualties that suggest that a more problematic and uneven stock market might be surfacing.

Unlike Cassandra, I am not saying the end of the world is near. (Bulls tend to dismiss bears with this one phrase.) Indeed, there is no reason to believe that Friday was the Big One. (Quite frankly, it has not paid to bet on the Big One, and probably won't for a while longer.)

It appears, however, that there are solid reasons to be increasingly concerned.

Most of my concerns, which I shall discuss below, are fundamental, not technical. I would add, however, that the negativity bubble you read about could not be further from the truth; just look at the Investors Intelligence sentiment studies, the high level of margin debt and/or the consistent raft of uninterrupted bullishness in the media.

Importantly, a confluence of a number of events is occurring at or near the conclusion of a mature economy in the U.S., Japan and Europe.

Without further ado, here are some (but not all) of my concerns:

• The pile of levered pools of capital that hold the extraordinary (in size and quality) amount of derivative assets are now in disarray. Mark-to-market issues and an acceleration in nonearning assets run deep and are endangering large bodies of market participants and their capital bases. This includes the domestic money center banks, investment brokerage firms and, importantly, the unregulated and monstrous special interests vehicles, collateralized debt obligations and levered hedge funds that play in that water.

  The destabilizing effect of the impaired financial institutions cannot be understated or underestimated; just ask those investors who have overweighted financials (20% of the S&P) on the basis of "value," only to see the sector drop on a daily basis. Banking problems tend to have a long tail and historically are not resolved in a quarter or two (e.g., the less-developed-country debacle, the junk bond fiasco and the early 1990s housing depression, all of which crippled the banking community for years).

  Arguably, the problems in housing and leveraged derivatives in 2007 run deeper than the prior adverse cyclical issues. Finally, we should not lose sight of the fact that the money center banks, which are this cycle's (and nearly every cycle's) dolt, entered 2007 ill-equipped to deal with losses. (They were at a historically low level of reserves as a percentage of earning assets.) The banks, too, were momentum players, believing in the new paradigm and believing (incorrectly) in their own credit standards and (lack of?) analysis.

  Recognizing that the level of credit losses virtually hit an all-time low in 2006, only to be reversed markedly through the first three quarters of 2007, a likely mean reversion-of-loss experience augurs poorly for a capital-depleted and off-balance-sheet-dependent U.S. commercial banking system that has experienced a two-decade drop in loan-loss reserves just as the economy matures and the consumer falters.

• To an important degree, the Fed has lost control of the capital markets. These are situations that cannot be arrested by somewhat lower interest rates. Many problems reside abroad outside of the Fed's influence. And much that is domestic lies in unregulated territory.
• Capital-weakened financial intermediaries spell an important retardant to the financing of growth. The era of unbridled lending is over. Just try to get a mortgage for a second home. Just try to get a jumbo mortgage. Just try to borrow with little or nothing down -- on anything. Or just try to get a nondocumented mortgage loan, motorcycle loan, furniture loan or automobile loan today.
• The next shoe to drop will be the failure of a public homebuilder and a private mortgage insurer. The latter concerns me more than the former, as the markets are not aware of the economic implications of my view.
• The domestic, nonexport economy is in recession. If you don't believe me, read last week's conference calls at Schlumberger (SLB - commentary - Cramer's Take), Caterpillar (CAT - commentary - Cramer's Take), etc. The Federal Reserve gets it and will likely lower interest rates by another 50 basis points next week. But the adoption of a Japanese solution of supporting bad debts will have, as an adverse consequence, further drops in our currency and competitiveness -- and higher prices for consumer products.
• Based on my recent trip, I can assure you all that the Western European economies are falling faster than is generally realized for many of the same influences behind the U.S. weakness.
• The dual impact of a higher real rate of inflation and climbing oil prices are a tax on the consumer and will weigh on corporate profit margins, which will be hurt by slowing top-line growth. Importantly, these are occurring at a time in which the consumer's debt load has never been higher based on nearly any measure. As I mentioned earlier, with declining home prices, the burden on maintaining financial net worth has never been more on the shoulders of stock prices, and that's a slippery slope. One might prefer to listen to some of the bullish managers interviewed on CNBC and Bloomberg (and now Fox Business News), who repeatedly defer to dogma in their general statement that "it has never paid to underestimate the American consumer."

  I prefer to look at some of the more tangible measures regarding the consumer's rocky fundamental position -- for instance, an all-time high in debt service and in the debt load of the consumer and, importantly, the message of the market from the Retail HOLDRs' (RTH - commentary - Cramer's Take) steady demise and the equally steady drop in bond yields -- as a precursor to the obvious slowdown.

• The excess capacity in housing holds far-greater economic import than the excess capacity in technology six years ago. Ben Stein wrote yesterday in The New York Times that "there is still a long waiting list for Bentleys in Beverly Hills."

  Unfortunately, there is no waiting list for low-end Fords or Chevrolets. That's the reason the Democratic Party's message of populism struck a chord in 2006 and is likely to influence the presidential election in 2008.

  Meager job and income growth and the squeeze on the lower- and middle-income classes at the tail end of a maturing economic cycle bodes especially poorly as the consumer's dependency on asset appreciation (stocks and houses) remains elevated. In the aforementioned Times article titled "The Gloomsayers Should Look Up," my email buddy, Ben Stein, further suggests that the ursine crowd should look up to see that the sky is not falling. By contrast, bears, like myself, suggest that when we look up to the sky, we will see dark clouds and headwinds. (Memo to Ben: $200 billion here, $200 billion there and soon we are talking about a lot of money!)

The next five years in the capital markets seem destined to be unlike the last five years. The most significant difference is that the egregious use, generation and packaging of debt will not be repeated -- and the consequences of that leverage will be adversely seen in areas of the world economies that we had never contemplated.

From my perch, the bulls continue to think very linearly and seem to be missing how significant the role of credit was to past growth and how significant a pullback in credit will be on future growth. Significantly, the markets continue to underestimate the consequences of leverage and are overestimating the prospects for corporate profit growth.

There will always be winners in the markets, just as there are always losers in the markets, and a number of contributors have brought up some beauties over the years. The winners appear to be narrowing in scope, however, representing a classic sign of a maturing equity market. And, in more difficult markets, those babies are often taken out with the bath water.

---

At time of publication, Kass and/or his funds were short the Retail HOLDRs, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.