Loaded Up on Leverage - TheStreet

Loaded Up on Leverage

There is a bubble in credit availability, credit costs and in investor activism.
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The market is approaching an unprecedented -- and dangerous -- crossroads: Not only is there enormous confidence in the notion of another long worldwide economic boom abetted by non-U.S. influences, but like in the late 1980s, there is a bubble in credit availability, credit costs and in investor activism -- i.e., buy stock, make a 13-D filing (a la Icahn), make waves and make a boatload of money.

It can't be that easy. (Remember the aborted United Airlines takeover in the late 1980s that brought an end to the speculation surrounding junk-bond financings?)

Moreover, leverage, as in past cycles, is playing a much more active role in today's hijinks. But, leverage is always the monster that kills, and it will likely have a primary role in upsetting this cycle as it has had historically.

Of course, in the last stages of an accelerating trend in prices, the consensus view always seems to look smart. Think back to the last two bubbles: the housing bubble that was formed in the early 2000s, and the stock market bubble emanating from the late 1990s.

To paraphrase Broadway hoofer Ethel Merman in


, "everything was coming up roses" for home prices and for Internet stocks.

Rose-colored glasses were the fashion du jour as the investment community was convinced of the new paradigm and long boom in home prices (and activity), in the unparalleled prospects for technology/Internet and in almost a zombielike trance in listening to the proselytizing by


magazine's Peter Schwartz and Peter Leyden that a

long and uninterrupted economic boom

was inevitable. "We're facing 25 years of prosperity, freedom and a better environment for the whole world. You got a problem with that?"

In evaluating the past housing cycle, however, investors ignored, up until the very end, the growing mortgage credit abuses that would undermine the cycle by stretching affordability to unfathomable levels. In the late 1990s, pie-in-the-sky valuations and daytrading's speculative excesses were ignored because, in the long run, stocks always rose and a


target of 36,000 was the exclamation point in James Glassman's


for all of us to read in late 1999 -- just prior to the


75% decline.

In the prior two bubbles/booms, prices were extended and exaggerated by borrowed funds or excess liquidity. Subsequently, the bubble's bursting of falling prices were exaggerated by the calling in of the credit-financed liquidity.

It is no different today, as I


in a


editorial in December 2006. Credit availability is unprecedented, and activism and

private-equity activity are bubblicious. Deals are being executed using ever-increasing leverage as credit spreads remain narrow and disbelief has been suspended. At the same time, fundamentals are not as sturdy as is generally accepted.

Grandma Koufax used to say, "Dougie, forewarnings are on your forearm. But for the time being, the joke is on you."

Consider the following:

  • U.S. housing: Housing's fall is accelerating and will weigh on economic growth for some time to come? No worry, the bulls say, as the bottom has to be near -- still-low historic mortgage rates, household formations, demographics, migration and job growth are supportive of a housing recovery.
  • Worldwide real estate: The bubble that began in the U.S. and spread around the world is showing signs of being pierced in Europe. No worry, the bulls say: Private equity is a buyer on any weakness.
  • Job growth: The Bureau of Labor Statistics' birth/death adjustment overstates job growth when the economy is slowing down. No worry, the bulls say, the economy will recover from the tepid first-quarter 2007 growth, and so will jobs.
  • Consumer: Department-store comps are in a free fall, and a 0.9% drop in retail sales (the largest decline since August 2005) is a further indication that the middle-income consumer is starting to spend less and that a general cooling in spending is on the horizon (as mortgage resets further pressure individuals). No worry, the bulls say, never bet against the consumer as high-end U.S. consumers are healthy and the emergence of a consumer class in the emerging markets will more than fill in the gaps.
  • Business spending: Even though business balance sheets are in terrific shape, a weakening consumer, lower home prices and subdued confidence will weigh somewhat on capital spending expenditures? No worry, the bulls say: Businesses have been underspending in this cycle, and a catch-up should be anticipated. (It's 1997 all over again!)
  • Corporate profits: Domestic profits are punk? No worry, the bulls say: International markets are the catalysts to growth.
  • U.S. dollar and earnings quality: An accelerating drop in the U.S. dollar? No worry, the bulls say -- 45% of U.S. corporate profits are derived overseas (and will result in foreign-exchange sales/profits benefits), and, as a result of the dollar's schmeissing, U.S. corporations are getting to be ever-cheaper takeover fodder.
  • Inflation: We now have $74 per barrel for crude oil (at the time of this writing on Sunday evening), rising wage rates, sky-high food prices and a near-record headline CPI. No worry, the bulls say: Core CPI, the price of laptops, cell phones and flat-panel TV screens are all receding. Inflation is contained.
  • Credit cycle: Credit availability is now being impacted by the subprime mess and a heavy inventory of product (bridge loans and takeover debt). No worry, the bulls say, the liquidity provided by the kindness of strangers will fill the void that is necessary to overcome the deteriorating domestic credit conditions.
  • Geopolitical: Al Qaeda gainingpower, the U.S.'s Iraq policy in shambles and Israel/Middle East a powder keg? No worry, the bulls say: We have to get used to it (as it has been that way for thousands of years).
  • Political: Increased evidence that the Democratic Party is moving toward a more onerous taxation policy? No worry, the bulls say -- it's a 2010 issue.
  • Sentiment: Margin interest at record levels, a bubble in optimistic sentiment? No worry, the bulls say, we are in a negativity bubble.
  • Private equity: The pace of private equity deals has begun to recede as credit spreads begin to widen, borrowers become more circumspect, and the supply of recycled private equity is queuing up to be taken public. No worry, the bulls say, liquidity remains an international event, and now foreign companies -- such as Rio Tinto (RTP) /Alcan (AL) - Get Report -- are getting into the act. And the almost endless supply of recycled takeovers poised to go public are a 2008-10 event.
  • Valuation: The Value Line Composite of the largest 3,500 companies trades at over 20 times earnings, the S&P"490 Index" trades at over 20 times earnings, the Nasdaq trades at 28 times earnings and the Russell 2000 P/E trades at around a 50% premium to the 2000 highs. No worry, the bulls say, the stated P/E of the S&P is at an historically reasonable 17 times.
  • Emerging markets: Conspicuous individual investor daytrading and speculation in markets like China are eerily reminiscent of the stock market bubble of the late 1990s. No worry, the bulls say, it's early in the cycle of speculation.
  • Criticism: Cynics deliver logical arguments regarding economic/market conditions? No worry, the bulls say, as naysayers are ridiculed as permabears; their arguments not worthy of consideration.

In bubblelike market conditions, when many fundamental threats and headwinds are increasingly ignored, stocks tend to overshoot reasonable levels of value until the worriers are totally discredited.

That time might be growing near.

At time of publication, Kass and/or his funds held no positions in the stocks mentioned, 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. Until 1996, he was senior portfolio manager at Omega Advisors, a $6 billion investment partnership. Before that he was executive senior vice president and director of institutional equities of First Albany Corporation and JW Charles/CSG. He also was a General Partner of Glickenhaus & Co., and held various positions with Putnam Management and Kidder, Peabody. Kass received his bachelor's from Alfred University, and received a master's of business administration in finance from the University of Pennsylvania's Wharton School in 1972. He co-authored "Citibank: The Ralph Nader Report" with Nader and the Center for the Study of Responsive Law and currently serves as a guest host on CNBC's "Squawk Box."

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