Kass: Short Side Never Looked So Good

Some reasons why today's drop is just the start.
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This column by Doug Kass was originally published Feb. 27 at 9:03 a.m. EST on Street Insight. It's being republished as a bonus for TheStreet.com and RealMoney.com readers. For more information about subscribing to Street Insight, please click here .

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.

As originally published, this story contained an error. Please see

Corrections and Clarifications .

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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