Capital Market Excess; Still Bullish on Bon-Ton: Best of Kass

NEW YORK (TheStreet) -- Doug Kass of Seabreeze Partners is known for his accurate stock market calls and keen insights into the economy, which he shares with RealMoney Pro readers in his daily trading diary.

Last week, Kass wrote about capital market excess and Bon-Ton Stores.

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A Not-So-Funny Thing Happened on the Way to Capital Market Excess

Originally published on Monday, Aug. 4, at 8:21 a.m. EDT

Something familiar,
Something peculiar,
Something for everyone:
A comedy tonight!

Something appealing,
Something appalling,
Something for everyone:
A comedy tonight!

Nothing with kings, nothing with crowns;
Bring on the lovers, liars and clowns!

Old situations,
New complications,
Nothing portentous or polite;
Tragedy tomorrow,
Comedy tonight!

Something convulsive,
Something repulsive,
Something for everyone:
A comedy tonight!

Something aesthetic,
Something frenetic,
Something for everyone:
A comedy tonight!

-- Music and lyrics by Stephen Sondheim, "Comedy Tonight" (from A Funny Thing Happened on the Way to the Forum)

Things are not always as they seem; skim milk masquerades as cream.

That was the lesson Pseudolus (portrayed by Zero Mostel, Nathan Lane, Whoopi Goldberg and many others) taught us in A Funny Thing Happened on the Way to the Forum, and it's the lesson we might be learning in the markets right now.

Normalization of profits, profit margins and interest rates will likely be a headwind to domestic economic growth and an albatross around the head of several investment asset classes in the period ahead.

Until recently, markets have willfully ignored the above in addition to rejecting the possible adverse investment consequences of expanding geopolitical risks in favor of, as my pal Mike Lewitt describes, "cold-blooded focus on central bank policy."

As I wrote several months ago, a mini Minsky moment might be at hand -- thanks to an exaggerated exploitation of portions of the equity and fixed-income markets and a growing attitude of complacency that has followed the exploitation of these asset classes.

The road to investment hell is paved with good intentions.

After the largest weekly decline in nearly two years, the markets are now near-term oversold, and a (weak) rally is possible in the next few days.

Similar to Pavlov's dog, market participants will be inculcated with the notion of buying the dips. You will hear this mantra from the business media, from investment strategists and even from your financial planners.

It is my view, however, that a more meaningful correction seems likely in the weeks and months ahead.

While it might be tempting to consider last week's drop as another opportunity to buy the dip (similar to earlier in the year), I suspect rallies should now be sold.

With breadth deteriorating and new highs falling, the market's character has changed, and numerous negative market tells abound (and have been heretofore dismissed until the past week).

  • Throughout the 2013-2014 rally, shallow market declines responded positively to favorable news, but the Thursday waterfall drop followed better-than-expected economic news -- namely, a 4% second-quarter 2014 real GDP reading.
  • I have often opined that some of the worst market declines occur when investors can't identify a catalyst for the drop or when good news is ignored -- such as it might be at the current time.
  • Just as rising markets tend to result in investors and traders focusing on good news (e.g., the specter of low interest rates and central bankers' "more cowbell"), the focus in a more significant drop might move toward the bad news -- and there is a lot to worry about (including a subpar global economic recovery, geopolitical risk, Washington dysfunction, the schism between the haves and have-nots).
  • The notion of buying the dip has remained ingrained -- equity inflows into domestic equity funds, and ETFs continue strong. This is unhealthy and, when in the extreme, historically points to more substantial declines.
  • Importantly, the quality of the recent advance and the internals has deteriorated with numerous classical technical divergences. The August-to-October period, as previously mentioned, is among the most seasonally weak periods in history.
  • Large-cap, multi-industry stocks with above-average dividend yields have led the market advance, but these stocks are now starting to lose strength. If the drop gathers momentum, these are vulnerable and heavily weighted in the indices, making them likely liquid candidates used to raise cash.
  • Generally speaking, the global equity rally is also beginning to get more selective -- another signpost of late bull market behavior.

I have contended in numerous postings that stock valuations are higher than meets the eye, as profit margins lie 70% above the six-decade average. Hence, earnings power is less than the 2014 consensus for the S&P 500 of $119 a share. Normalizing of profits (and profit margins) produces current P/E multiple readings that are well above generally thought of valuations and higher than historical averages.

But what make the recent correction likely to morph into something more than a few percentage points decline are considerations of a credit kind.

Credit, even more than equity, is the lifeblood of economic growth.

When taken to the extreme (as we witnessed in the mid-2000s), our economic and investment world turns upside down when credit conditions tighten and/or deteriorate.

There is, to this observer, a bubble in elements of the credit market.

Most investors have been lulled into a sense of complacency in recent months. Self-confident bullishness has had little or no appreciation of the potentially adverse consequences of the bubble-like conditions and speculative orgy (especially in the issuance of corporate bonds) or in the remarkable performance of high-yield/junk bonds.

Surprisingly, most observers fail to recognize one important fact -- namely, that the generational low in interest rates has masked the astonishing notion (and disguised the negative impact) that net corporate debt today lies a full 40% over the levels of 2008 (source: Societe Generale's Andrew Lapthorne).

That's right: Record corporate cash balances have been eclipsed by all-time debt issuance -- little of which has been used for capital spending, and most of which has been used in corporate share buybacks and larger dividend payouts.

In other words, we (in the U.S.) are more addicted to debt than at any other point in modern financial history. Debt loads (as illustrated in Argentina's recent default) are much higher outside of the U.S.

"On a policy level, it is virtually impossible to direct capital to productive uses with tax policies that favor debt over equity, speculation over production, and non-U.S. over U.S. economic activity."

-- Mike Lewitt, The Credit Strategist

Interest expenses (particularly in a rising rate environment) will take away from productive growth and will increasingly weigh on global growth -- just as the U.S. stock market is virtually at a new high and more than double that level of the generational bottom in 2009.

As a result, some strange things might occur in the years ahead as interest rates normalize.

Low interest rates are entrenched in our economy, psyche and society.

Rising interest rates may be an anathema and could dent the five-year domestic economic recovery (particularly in housing and in autos).

The last federal funds rate hike was all the way back in June 2006 -- that's eight years ago! Low interest rates have the capability of distorting and stretching out investing time. But higher interest rates, in a still levered world, may compress investing time.

Gluskin Sheff's David Rosenberg reports that since 1977 there have been six cycles of rising rates, producing, on average, a 10% drop in the stock market indices, and they have had a median and mean duration of 75 days and 140 days, respectfully. During that time frame, the three-month U.S. Treasury bills and 10-year U.S. notes rose by, on average, 75 basis points.

Last week, we saw the tip of that iceberg in a fall in equities and in disruption in the credit markets.

Up until last week, warnings have been ignored.

Asymmetrical policies over successive business and financial cycles can impart a serious bias over time and run the risk of entrenching instability in the economy. Policy does not lean against the booms but eases aggressively and persistently during busts. This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy -- a debt trap. Systemic financial crises do not become less frequent or intense, private and public debts continue to grow, the economy fails to climb onto a stronger sustainable path, and monetary and fiscal policies run out of ammunition. Over time, policies lose their effectiveness and may end up fostering the very conditions they seek to prevent.

-- Bank for International Settlements' 84th Annual Report

Take a look at what a modest rise in mortgage rates (from generational low levels) have already done to the residential real estate market over the past 12 to 18 months. Those who suggest that mortgage rates are low by historic standards miss the fact that younger homebuyers have no experience in a world of higher rates -- they are conditioned to the low mortgage rates of the last 10 or 15 years. Most first-time homebuyers were not adults  when rates last rose dramatically in the early 1980s -- they know of only mid-single-digit mortgage rates.

And in the past, a domestic economic recovery has yielded higher real personal incomes. By contrast, in this cycle the necessities of life have risen in cost, while salaries and wages have flattened (what I describe as "the screwflation of the middle class"). When you combine this with the proliferation of new-era homebuyers (i.e., institutional, hedge funds, private equity, new vehicles such as Altisource Residential  (RESI) and its ilk), that have buoyed home prices, home affordability has significantly deteriorated.

With net corporate debt so much higher since 2008-09, a consequential rate rise will further choke off corporate profits, capital spending and buyback plans. The latter is particularly true regarding a vulnerable high-yield market. Moody's Investors Service reports that junk-rated borrowers have nearly $750 billion of debt coming due in the next five years. Junk bonds are an important source of stock market demand through corporations' share buybacks.

Summarily, since early July there has been a confluence of indicators suggesting that our capital markets are vulnerable to something more than a shallow correction.

The pressures are now intensifying.

Tops are a process, and signs lead to the possible view that the worst might lie ahead for the U.S. stock market.

Nothing with gods, nothing with fate;
Weighty affairs will just have to wait!

Nothing that's formal,
Nothing that's normal,
No recitations to recite;
Open up the curtain:
Comedy tonight!

Something erratic,
Something dramatic,
Something for everyone:
A comedy tonight!

Frenzy and frolic,
Strictly symbolic,
Something for everyone:
A comedy tonight!

-- "Comedy Tonight" (three-minute mark)

Err on the side of conservatism.

At the time of publication, the author held no positions in any of the stocks mentioned, although positions may change at any time.

Still Bullish on Bon-Ton

Originally published on Monday, Aug. 4, at 11:19 a.m. EDT

The retail sector, which I have generally avoided, continues to be under pressure.

My sole exposure has been Bon-Ton Stores  (BONT).

In the last few days, there have been several management and board changes that I have commented on, and I would like to repeat them.

First, the company hired Daniel Molutsky to its board of directors. Molutsky was a Lazard banker, involved principally in mergers and acquisitions. I would read this as a potential sign that the retailer might be considering strategic options in the future.

Bon-Ton Stores also appointed a new chief executive to replace Brendan Hoffman, who announced his intention to leave the company (for personal reasons) several months ago. Though she will have only a modest impact on 2014 results (merchandise has already been selected and purchased), new CEO Kathryn Bufano is extremely well-regarded and has a strong, multichannel background in the retail industry.

The shares of Bon-Ton have responded positively to these appointments.

As previously written, I am not looking for much out of the quarter to be recorded later this month.

But the company will be the beneficiary of lower oil prices and improving weather in the northern part of the country in the second half. Cost efficiencies are in place and should also lead to a better 2015.

I continue to see a positive reward vs. risk in Bon-Ton shares. Downside risk is around $8 a share, and upside reward is over $15 a share.

A takeover could be icing on this cake.

I plan to add on any weakness -- particularly if investors take the shares down further on the  second-quarter 2014 EPS announcement (which is a seasonally weak one and should produce a relatively large loss).

At the time of publication, the author was long BONT, although positions may change at any time.

TheStreet Ratings team rates ALTISOURCE RESIDENTIAL CORP as a Hold with a ratings score of C-. TheStreet Ratings Team has this to say about their recommendation:

"We rate ALTISOURCE RESIDENTIAL CORP (RESI) a HOLD. The primary factors that have impacted our rating are mixed ? some indicating strength, some showing weaknesses, with little evidence to justify the expectation of either a positive or negative performance for this stock relative to most other stocks. The company's strengths can be seen in multiple areas, such as its robust revenue growth, notable return on equity and attractive valuation levels. However, as a counter to these strengths, we find that we feel that the company's cash flow from its operations has been weak overall."

Highlights from the analysis by TheStreet Ratings Team goes as follows:

  • RESI's very impressive revenue growth greatly exceeded the industry average of 10.5%. Since the same quarter one year prior, revenues leaped by 1206.2%. Growth in the company's revenue appears to have helped boost the earnings per share.
  • Compared to other companies in the Real Estate Investment Trusts (REITs) industry and the overall market on the basis of return on equity, ALTISOURCE RESIDENTIAL CORP has outperformed in comparison with the industry average, but has underperformed when compared to that of the S&P 500.
  • The gross profit margin for ALTISOURCE RESIDENTIAL CORP is rather high; currently it is at 62.57%. Regardless of RESI's high profit margin, it has managed to decrease from the same period last year. Despite the mixed results of the gross profit margin, RESI's net profit margin of 58.41% significantly outperformed against the industry.
  • Net operating cash flow has significantly decreased to -$20.98 million or 547.23% when compared to the same quarter last year. In addition, when comparing to the industry average, the firm's growth rate is much lower.
TheStreet Ratings team rates BON-TON STORES INC as a Sell with a ratings score of D+. TheStreet Ratings Team has this to say about their recommendation:

"We rate BON-TON STORES INC (BONT) a SELL. This is driven by multiple weaknesses, which we believe should have a greater impact than any strengths, and could make it more difficult for investors to achieve positive results compared to most of the stocks we cover. The company's weaknesses can be seen in multiple areas, such as its deteriorating net income, generally high debt management risk, disappointing return on equity, weak operating cash flow and generally disappointing historical performance in the stock itself."

Highlights from the analysis by TheStreet Ratings Team goes as follows:

  • The company, on the basis of change in net income from the same quarter one year ago, has underperformed when compared to that of the S&P 500 and the Multiline Retail industry average. The net income has decreased by 18.3% when compared to the same quarter one year ago, dropping from -$26.64 million to -$31.51 million.
  • The debt-to-equity ratio is very high at 9.40 and currently higher than the industry average, implying increased risk associated with the management of debt levels within the company. Along with this, the company manages to maintain a quick ratio of 0.10, which clearly demonstrates the inability to cover short-term cash needs.
  • The company's current return on equity has slightly decreased from the same quarter one year prior. This implies a minor weakness in the organization. Compared to other companies in the Multiline Retail industry and the overall market, BON-TON STORES INC's return on equity significantly trails that of both the industry average and the S&P 500.
  • Net operating cash flow has significantly decreased to -$15.80 million or 258.87% when compared to the same quarter last year. In addition, when comparing to the industry average, the firm's growth rate is much lower.
  • Looking at the price performance of BONT's shares over the past 12 months, there is not much good news to report: the stock is down 43.66%, and it has underformed the S&P 500 Index. In addition, the company's earnings per share are lower today than the year-earlier quarter. Naturally, the overall market trend is bound to be a significant factor. However, in one sense, the stock's sharp decline last year is a positive for future investors, making it cheaper (in proportion to its earnings over the past year) than most other stocks in its industry. But due to other concerns, we feel the stock is still not a good buy right now.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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