This blog post originally appeared on RealMoney Silver on Feb. 25 at 7:27 a.m. EST.
I have recently argued to buy the dips and sell the rips, a seemingly robotic attempt to extract excess returns from what little Mr. Market has been giving us over the last several months.
Unfortunately, the idea of this sort of strategy conjures up a boiler room of trading automatons that strictly rely on a machine-like response on stock market price weakness to buy and share price strength to sell/short.
It is not what I am entirely trying to communicate.
The buy the dips, sell the rips strategy certainly does not mean that analysis and perspective should be jettisoned. Indeed, it is more important than ever, as the benefit of experience has helped us greybeards navigate an increasingly difficult market landscape.
Logic of argument, thorough financial analysis and a complete dissection of numbers remain my investment mantra.
Case in point: Recent evidence suggests that some of the huge financial writeoffs and writedowns of a variety of credits at our leading financial institutions might have been exaggerated. This could lead to financial writeups over the next one or two years.
If this supposition is correct, there is a fortune just waiting to be made in the financial sector.
- On page M14 in this weekend's Barron's, levered loans are trading at about 88 cents on the dollar. By contrast, the market is expecting a 10% to 15% default rate, a level that has never been seen according to KDP Advisors. In fact, says KDP, "The loan market is trading with a higher default rate than the junk bond market, very bizarre given that leveraged loans are secure debt and are senior to bonds in corporate capital structures." So, levered loans are trading well below fundamentals.
- The same holds true for high-yield bonds, in which the current default rates stand at 1.5%, implied by spreads are 8% defaults, and expected by ratings agencies (like Moody's) is only 5%.
- The same holds true for commercial real estate loans, in which the current default rate is 0.3%, implied by CMBX is 8%, and the expected default rate, according to credit professionals I rely on, is expected at only 2%.
One could conclude from the above that there is a mistaken pricing of debt that is causing larger-than-necessary financial sector writeoffs, similar to when portfolio insurance kicked in and forced investors to sell stocks during the October 1987 market crash.
If my observations are correct, a mistaken pricing of debt is serving to constrain bank lending, slow the economy and has produced artificially low stock prices (especially of a financial sector-kind) as investors could be overreacting to the huge financial writedowns at some of the world's largest financial institutions.
Doug Kass is the author of The Edge, a blog on RealMoney Silver that features real-time shorting opportunities on the market.
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.