The self-proclaimed "anti-Cramer," Doug Kass, anchors
"The Edge," a diary about stocks and investing. As a dedicated short-seller, Kass can seek out the bear market in any environment.
This week, he discussed
why the short side never looked so good
the next shoe to drop
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Short Side Never Looked So Good
Originally published on 2/27/2007 9:03 a.m. EST
Despite too often sounding like the boy who cried "wolf" in light of the continued market ascent, I have spent the past several weeks outlining my investment rationale and my major concerns:
heightened debt loads
among consumers, the government and hedge funds;
rising mortgage credit losses, which will weigh on a spent-up, not pent-up consumer;
nascent inflation, seen in rising raw materials spot prices and crude lately; the ever-present specter of geopolitical tensions; and
corporate profit and profit margin vulnerability.
Above all, investors are not being paid for risk -- and excessive valuations are not being recognized. As Robert Marcin
pointed out Monday, today's median P/E of 20.5 times trailing earnings of the Value Line composite of 3,000 leading companies compares to 14.5 times at the market's top in the fall of 2000; meanwhile, credit spreads and volatility --expressions of copious complacency -- remain at record low levels.
Here are some reasons we're at such a precarious point.
- 1. Brokerages and money center banks are rolling over badly and remain a negative short-term market tell.
2. Hedge fund net-long invested levels (61%) are at the highest level and the AAII survey has bears at the lowest level since December 2004.
3. The daytrading in the Chinese market has begun to eerily resemble daytrading in the
Nasdaq, which peaked seven years ago. (The more things change, the more they are the same, though the location changes.)
4. Virtually every hedge fund has the yen carry trade on its books, and recent signs in the currency markets indicate that the trade is getting less compelling. (If it does begin to unfold, the young hot money -- especially in the emerging markets like China -- could reverse in a nanosecond).
5. Further signs of speculation are the press mentions (and market reactions) of far-fetched takeovers. A classic example was Monday's item in England's
Sunday Express that
Dow Chemical (DOW) - Get Report might be acquired by a private-equity group. The shares briefly rose by 8% in response.
Two weeks ago, England's
Times of London published a report that
Countrywide Financial (CFC) would be acquired by
Bank of America (BAC) - Get Report. Again, the shares rose by nearly 10%, though they have subsequently declined by nearly 15% as subprime problems have grown. The outsize reactions to less-than-legitimate sources is typical these days.
6. History shows that four-year extensions of bull markets, out of deep oversolds, often morph into disaster: 1932-36 (1937 crash); 1957-61 (1962 crash); and 1982-86 (1987 crash). We're well into four years in the current stretch.
7. Writing again on history (and technical voodoo), over the last century every decade has seen a market crash/deep correction in the sixth or seventh year of that decade.
Above all, the lifeblood of the bull market is the availability of credit, and the subprime issues (dismissed by most, not surprisingly) are putting a halt to lending that for years has disregarded creditworthiness and plain common sense. As night follows day, personal spending will plunge just at a time when most believe the consumer is invincible.
The opportunities on the short side have never been more attractive, just as the signs of a breakdown of the impressive bull market run have started to appear -- a potentially lethal combination.
Finding the Next Shoe to Drop
Originally published on 3/2/2007 12:32 p.m. EST
, the largest originator of home loans in the U.S.,
in its prime mortgage loans.
At year-end 2006, Countrywide's subprime delinquencies were approaching 20%. That's nearly twice the rate reported by the subprime industry in November and it suggests that the upward spiral in subprime-industy late payments will rise dramatically in 2007. (New data from First American Loan Performance, a San Francisco-based research firm, confirmed this likely trend, reporting that nearly 14% of packaged subprime loans were delinquent.)
More importantly, these results confirm that credit problems will not be contained to the subprime mortgage market. At Countrywide, prime mortgage-lending delinquencies doubled to nearly 3% year over year, indicating that that sector is experiencing the same contagion that subprime experienced over the last 12 months.
On Tuesday, in response to the subprime carnage,
tougher subprime lending standards.
and other regulators of banks are expected to release new subprime lending guidance, which will incorporate the impact of mortgage interest rate resets.
As a result of new lending standards and self-imposed reductions in mortgage lending, the availability of mortgages is going to be severely crimped -- and with it, personal consumption expenditures will soon take a dive.
It is no wonder that bullish commentators are getting bored with subprime lending problems. Larry Kudlow's
, who, like Dante, Dostoevsky, Nietzsche and Proust, view the world through the lens of a single defining idea ("the greatest story never told"), are about to be outwitted by the foxes who, like Shakespeare, Aristotle, Balzac and Joyce, draw on a variety of experiences in creating their investment mosaic and refuse to believe that the world can be boiled down to a single idea.
The Next Shoe to Drop?
With the contagion that started in subprime mortgage lending now spreading to other mortgage tranches,
, the next shoe to drop might well be in the broader securitization market.
Not only will older, less-protected packaged securitizations and other derivatives decline in price in a readjustment, but the entire credit securitization chain will become less profitable to industrial companies, mortgage lenders, banks and brokerages.
Consider what has occurred and is now occurring in subprime. The prices of mortgages are rising as the originations become less profitable for the financial intermediaries that serve the market. In turn, housing affordability worsens, delinquencies and foreclosures rise, housing inventories build further, and home prices drop in the second leg down for residential real estate.
This is the vicious cycle and contagion in credit markets.
Now I am hearing stories of plunging demand for CDO tranches and sponsors taking large fee-haircuts before deals can be sold. It is in the mixed asset class of CDOs where the contagion of subprime might soon spread as buyers recoil from sharper-than-anticipated losses in the mortgage market.
Credit spreads are flying open and the vicious cycle of credit has begun as the evaluation of risk is reassessed.
Given the sheer size and significance of the unregulated credit derivative markets, this is the kind of stuff that capital market crashes are made of.
At time of publication, Kass and/or his funds were short CFC, 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 $4 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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