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Kass: Ready for the Bear Stearns Challenge?

Doug Kass

This blog post originally appeared on RealMoney Silver on March 17 at 8:37 a.m. EDT.

"But these waves we are battling, caused by the biggest hurricane in 20 years, had been pounding the shore relentlessly. Although I wouldn't admit it to George (Soros), it was very clear to me that something unusual was going on."

-- Victor Niederhoffer, The Education of a Speculator

The sale of Bear Stearns (BSC Quote) at a price of $2 per share to JPMorgan Chase (JPM Quote) will have short-term negative reverberations around the world as the credit quality of the leading financial institutions will come into question. While it was an illiquid balance sheet and the lack of institutional confidence that brought Bear Stearns down (as panic and margin clerks are today's voting machines), the price tag of $2 per share could raise more questions than it answers. After all, the general impression was that the company's headquarters were worth over $1 billion and that the prime brokerage business was worth at least $2 billion, or 4 times last year's cash flow of $550 million. These factors suggest that there must be more to the story.

Nearing a Bottom?

Last Thursday, I argued that "it's different this time." Stated simply, the housing and credit bubbles have been unprecedented in scope and duration -- and so has the novel and astonishingly large increase in debt (especially of a consumer kind) as all elements of risk control and due diligence were abandoned in the quest for yield enhancement. Meanwhile, amidst these bent secular influences, the reckless proliferation of unregulated and unwieldy derivatives continued, seemingly limited only by the imagination of man (or mad men).

And as I wrote on Wednesday, there is no single policy that will politely eradicate the egregious and out-of-control buildup in debt and the proliferation of unregulated derivatives in our shadow banking system. And as I said that night on "Kudlow & Company," the natural forces of a business downturn seem the only solution to what ails the equity and credit markets.

Piecemeal and oldfangled policy responses to newfangled problems will no longer work and, in many cases, will lead to adverse and unintended consequences. Deleveraging out of the most recent cycle will be a rabid bitch. There will be many more currency, economic and hedge fund casualties. The Fed can only do so much -- any more could jeopardize the world's view of its creditworthiness, which would serve to put even more pressure on our currency.

The market is now catching up to my above views as stocks tumble back toward the lows established in mid-January.

"Charlie (Munger) and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both with the parties that deal with them and the economic system."

-- Warren Buffett, 2002 Berkshire Hathaway letter

At the core of the equity market's and economy's problems are:

1. the derivative issue; and

2. the increased role that leverage and credit have had on worldwide economic growth and on speculative activity in all corners of our financial system.

To get some sense of the complexity of the derivative threat, I strongly suggest that subscribers consider reading pages 12-14 of Warren Buffett's 2002 letter to shareholders of Berkshire Hathaway (BRK.A Quote) for a fuller understanding. I may continue to be short his stock, but, once again, his wisdom and insights run true -- well before the issue became au courant.

Back in the summer of 2007, I suggested that, based on the degradation of the credit markets, a 25% decline in equities from the high might be anticipated. At today's opening, we will be close to that decline in percentage points, which has historically coincided with a bear market low.

Most of the time, it does not pay to invest on the basis of the view that "it's different this time" -- after all, multiple sigma events are just that, and, by definition, they occur infrequently. Victor Neiderhoffer, who I quoted at the start of this column, devotes his Web site, Daily Speculations, to applying historic reasoning in order to understand the current state of the market -- and how to respond tactically.

Unfortunately a 2-3 sigma event occurred in the housing market by 2005-2006, when housing affordability was stretched to unfathomable levels, and a "black swan" event is now in full force in the credit markets, thanks to many of the aforementioned secular developments.

The ultimate question is whether a small cabal of ne'er-do-wells at the banks and brokerages have infected the entire financial system with such large amounts of toxic paper so that traditional analysis of business/market cycles, the stock market's historical role of discounting an economic upturn after a recession and other factors lose their relevance as issues of liquidity, contagion and solvency gain center stage in a Shakespearean tragedy entitled "Avarice, Leverage and Hubris."

If so, the 1930s could be repeated -- and so could the Nasdaq's 75% swoon of 2000-2002.

But I doubt it.

Bear Stearns: The Failure of Not Diversifying

History might not repeat itself, but it sure rhymes. Or as Yogi Berra once said, "It's like déjà vu, all over again."

The decade of the 1980s gave birth (and death) to an upstart brokerage firm, Drexel Burnham, which created, sold and traded high-yield junk bonds -- the turbo debt and foundation of the previous "decade of greed." After the insider trading indictment of Drexel's Denis Levine was followed by Michael Milken's demise, junk bond liquidity dried up, recession befell the U.S. economy, and, by 1990, default rates on high-yield debt more than doubled to over 10%. Drexel, forced to buy the bonds of its junk bond clients, depleted its capital and filed bankruptcy.

In much the same manner as Drexel did in the junk bond market, Bear Stearns emerged as a leader in a parabolic growing market -- mortgages. As we are now witnessing at Bear Stearns (as we did during the Drexel era), a brokerage's well-being relies, in large measure, on the kindness and confidence of strangers to accept its collateral and accept counterparty risks. That confidence is impaired swiftly when price discovery unveils a diseased portfolio of assets, which is further exacerbated by a high degree of leverage employed. This is especially true when the brokerage's business is not diversified and is narrow in scope -- Drexel (junk bonds) and Bear Stearns (mortgages).

Following the Drexel bankruptcy and a real estate-led recession, the equity market regained its footing in late 1990. It didn't take much time - the same could hold true in 2008-09.

A One-Off Situation

The principal investment question at hand is whether Bear Stearns was a one-off situation -- whether its business was so levered and narrow in focus (mortgages) that, with its revenue base collapsing, operating losses would quickly have eaten up its $85-plus per share book value.

I would argue that, in the main, Bear Stearns (like Drexel Burnham was) is indeed a one-off situation -- much like when Penn Central shocked the financial system 28 years ago.

While the credit conditions suggest that it is different this time, my investment conclusion is that we are likely at the beginning of the end. As was the case of the Drexel bankruptcy, however, we are not at the end of the current crisis (as the deleveraging process will take more time).

Buying Into Panic

The infinity of political, economic and psychological factors that influence the investment mosaic overloads the senses -- more so today than in most prior periods. Six weeks ago, I evaluated the market's positive and negatives. When I revisit these factors today, I can see the balance tipping over toward the positive ledger -- but only after we digest the Bear Stearns news.

That indigestion could take a day, a week or a month. No one can be sure of the timing.

Here are some (weighing not voting) considerations that could buttress the markets and/or suggest that the current issues could be in the process of being discounted in the markets, forming the basis for the potential for a more constructive view in the days/weeks/months ahead after the panic subsides:

• The curative and clearing process, addressing many of the financial institution's capital issues, has been under way for months. Though the Three Stooges of 21st Century Finance (i.e., the Executive Branch, Federal Reserve and Treasury Department) have been timid and unimaginative, last week's actions by the Fed and the rescue of Bear Stearns are a start in the right direction. And even Bush, Bernanke and Paulson are beginning to recognize the immediacy of the problems -- and the need for outside-of-the-box solutions (like investment banks' access to the discount window).
• We are bottoming, not yet recovering in housing. Some permutation of the Barney Frank/FHA proposal seems inevitable, particularly in an election year. Regardless, home prices are finally descending at an accelerating rate, and the more realistic prices will no doubt begin to attract buyers as credit availability stabilizes. I still do not expect a housing recovery until 2010, but the vision of stability is within sight by next year.
• Corporate balance sheets are in great shape and should buttress the current credit issues.
• Sovereign wealth funds remain flush (though relatively uncommitted) and stand ready to commit opportunistically to shore up capital of some of the U.S.'s largest financial institutions.
• The yield curve's steepening could, in the fullness of time, incent banks to take more risks.
• Corporate profit expectations, which were unrealistic until recently, are being pared quickly and are catching up to my downbeat projections. Fourth-quarter 2007 earnings (including financials) dropped by over 20% and are now anticipated to drop by nearly 10% in first quarter 2008. More importantly, unlike prior recessions, the credit problems are not trickling into other market sectors. Taking out financials, fourth-quarter 2007 profits rose by about 11% and are estimated to expand by about 7% in the current period.
• Over the last 50 years, job losses (a lagging economic indicator) have coincided with economic stabilization and a positive turn for equities. For example, reports of midsummer 1990 job losses were followed by a recovery in stocks that began in October, only two and a half months later. Ten years previous to that recession, stocks stabilized a month before job losses began occurring.
• Stocks have declined by 20% within a six-month period for the fourth time in a quarter of a century (1990, 1998, 2000). In the 12-month period following the 1990 and 1998 corrections, stocks rallied by 34% and 39%, respectively. The 2000 correction, however, begot a full-fledged Bear Market.
• As I have noted previously, unlike previous bear markets, equities were not the subject of speculation at the top; commodities, residential and non-residential real estate, and private equity were.
• If corporate profits avoid a major slide in 2008, stocks are inexpensive relative to short- and long-term interest rates. Indeed, with a seeming bubble in the bond market, a broad reallocation of assets out of fixed income and into equities seems possible.
• With the speed and momentum of the credit crisis intensifying coupled with a continued weakening in economic activity (especially of a job kind), the negativity bubble now appears so inflated that it could be ready to pop. For example, the equity-only put/call reached an all-time high on Friday, the Investors Intelligence (of market letters) survey showed bears rising to levels not seen in six years and demonstrated one of the sharpest weekly increases (to 43.6%) in years, the AAII survey (of individual investors) came in at the largest level of bears (at 59%) in nearly 20 years, and the consensus survey of futures traders were (only 23% bullish) at the lowest levels seen in over five years. These instances display a negative sentiment extreme rarely seen -- even at bear market lows.

Intermediate-Term Opportunities Are Emerging

Most should continue to maintain below-average sized positions in order to take advantage of what Mr. Market presents, as an opportunistic approach to trading/investing remains my mantra. Erring on the side of conservatism remains an appropriate strategy for individual investors.

Frankly, it's time to let the market do its talking, not the pundits. My guess is that we will "know" the answer sooner than later and that the outcome (at some undefined time) will be more positive than most appear to believe this morning.

I am now making the hardest decision -- again, only for the most facile traders/investors -- as I am getting more constructive (mildly bullish) on my intermediate-term market outlook on the basis that we are now at the beginning of the end of the credit crisis.

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Doug Kass is the author of The Edge, a blog on RealMoney Silver that features real-time shorting opportunities on the market.

Know What You Own: JPMorgan operates in the financial services industry, and some of the other stocks in its field include Citigroup (C Quote), Goldman Sachs (GS Quote), Morgan Stanley (MS Quote) and Merrill Lynch (MER Quote). These stocks were recently trading at ($18.21, -7.94%), ($143.80, -8.31%), ($34.18, -13.55%) and ($39.04, -10.27%) respectively. For more on the value of knowing what you own, visit TheStreet.com's Investing A-to-Z section.