Der USA Bären-Thread

Doug Kass has appeared numerous times in Barron's,  having penned his first guest column for us in 1992, on the case for  shorting Marvel Comics stock. Those who want more of his humorous and  distinctive views on stocks and companies can follow his blog on seabreezepartners.net  or watch his frequent TV appearances. A onetime Nader's raider (he  wrote a book about Citibank with consumer advocate Ralph Nader), Kass,  63 years old, invested money for such firms as Omega Advisors,  Glickenhaus & Co., and Putnam Management before founding his firm in  1997. In his latest Barron's interview, the former housing analyst talks about the recovery in housing and why he's shorting Goldman Sachs .

                    Barron's                 : You recently cut your long exposure. Why?

Kass: I've been cautious for two years,  reflecting the unique structural challenges and head winds that have  produced subpar jobs growth and tentative profits growth. Nothing has  transpired to make me change my view. Four factors form the potential  for a toxic cocktail. First, global growth is slowing. The outlook for  corporate profits is worsening, the U.S. is experiencing the third pause  in a subpar recovery that began in '08, the euro zone is in recession,  and important growth markets like China and India are sputtering.  Second, monetary easing is losing its effectiveness. Responsible fiscal  policy now holds the key to economic success. Third, the U.S. and  euro-zone leaders remain inert and dysfunctional, divided on ideological  grounds. At the beginning of the year, I hoped concessions would be  made. That hasn't happened. As we move closer to the November elections  and the fiscal cliff, election paralysis has set in. Our leaders are  acting like grade-schoolers. The European leaders are even less focused  on real change. The recent Brussels summit provided baby steps, not bold  initiatives. Finally, we have a negative feedback loop hurting  confidence in the markets. The potential exists for a further downward  spiral in the months ahead.

What happens to the market?

I look at four basic outcomes. First,  economic re-acceleration above consensus, which I give a 5% probability.  Second, below-consensus growth, a 40% probability. Third, a  muddle-through, a 50% probability. Fourth is a recession, precipitated  by loss of business and consumer confidence, a 5% probability. This is  the worst case. The Democrats regain the White House and the Senate, the  Republicans regain the House, and the rancor of partisanship during the  debt-ceiling deliberations gives us a further deterioration in  confidence. The housing market seizes up. The fiscal cliff is not  remedied or addressed. QE3 is instituted, but fails to contain the  weakness, because it is pushing on a string. The European recession  deepens. We have hard landings in China, in India. Then next year's  Standard & Poor's 500 earnings are materially reduced from an  expected $116 to $80, and stocks have a huge correction.

Yet you recently quoted the late Barton Biggs  saying: "When your partner is deeply distressed, depressed, and in a  dark mood and offers to sell his share of the business at a huge  discount, you should buy it."

Barton was talking about sentiment.  Classically, lousy sentiment implies good market value. I'm not so sure  that should apply going forward. Since 2007, $400 billion of outflows by  individual investors have come out of domestic equity funds, and they  committed nearly a trillion dollars to no- or low-yielding fixed-income  funds.

Sentiment and expectations are low for a  number of reasons. First, a decade of underperformance. Second, two  large drawdowns of stocks in the past decade—from 2000 to 2002 and from  2008 to 2009. Three, what I call the screwflation of the middle class,  where the average Joe sees stagnating income, while the cost of  necessities rises. Buying stocks is low on his list of priorities.  Fourth, the flash crash in 2010 scared the crap out of everyone, and we  still don't know the reason for it.

Today's trading is dominated by robots  and algorithms. They don't display remorse or conscience. They can't  read a balance sheet or an income statement. They lead to exaggerated  market moves that further alienate hedge funds and retail investors. How  can sentiment measures take that into account? Finally, all these  market scandals and loss of investor money with Bernie Madoff, Allen  Stanford, MF Global, and now Peregrine Financial are important.

Let's have some investment ideas. You are short the brokers. Why?

A few basic reasons. The business model  has been disrupted. There will be far less capital-markets activity in  the future, in investment banking, proprietary trading, institutional  and investment advisory, where competition will be heated. The  prop-trading profile wasn't helped by the JPMorgan   [ticker: JPM] trading gaffe or the recent revelation that Barclays    [BCS] and others manipulated Libor. The next three to four years will  be disruptive. Second, on a short-term cyclical basis, industry  conditions are very weak. Third, adverse secular changes will translate  into considerably lower industry returns on invested capital and  profits. And restoring the run rate of return on equity yields more  questions than it answers.

If we go back and look at a composite of JPMorgan, Bank of America   [BAC], Citigroup [C] and Morgan Stanley    [MS], you'll see that back in '07, their return on tangible capital was  around 25%. Last year, it went down to 8% because return on equity was  cut in half from regulatory and capital-rule changes; there were lower  capital-market volumes, and higher expenses.

I can't see that 8% going materially  higher, and I would say it will range between 8% and 12%. It will still  be cut by further changes in leverage ratios. We'll probably get a  recovery in capital-market volumes at some point. We'll probably get  higher rates. We'll get regulatory revenue mitigation, like changing  pricing, adding charges for checking accounts and debit card use. We'll  get lower expenses. That will contribute to a modest net gain from the  8% returns. So trade the sector, don't invest in it.

Take Goldman Sachs'   [GS] reported 7% return on tangible equity in the second quarter. In the second quarter of '07, it was 25%.

Goldman is already down by 25% over one year, to around $98.

I believe it's a value trap because of  the cyclical and secular influences. My price target is $80 a share. You  can see the secular change in return reflected in the sorts of business  they have begun to ramp up, with a new business unit that will lend  more directly to corporations, and expanding investment management.

The swashbuckling style that created  25% to 30% returns from the business of proprietary  trading are being  buffeted by a wave of new regulations, market turmoil, bad PR. They are  reshaping to a lower margin, lower valuation sort of business. I have it  in a paired trade that is long Oaktree Capital    [OAK], a defensive alternative-asset manager that trades at a discount  to the others as measured by equity capitalization to assets under  management. They are conservatively run and have historically been  protective of capital in difficult market backdrops. They have the best  management and are led by a hero of mine, Howard Marks, who wrote a  great book called The Most Important Thing.

What else?

In my last interview with Barron's in 2009 I said my stock of the decade was Altisource Portfolio Solutions   [ASPS]. It was trading at $15 and was spun off from Ocwen Financial    [OCN], which I also own. The real positive influence of the U.S.  economy to me is the housing market, which is embarking on a durable  multiyear recovery that will continue through the balance of the decade.

Ocwen is the largest subprime-mortgage  servicer in the U.S. Banks are disaggregating themselves from the  mortgage-servicing business, which tends to be capital-intensive and is  now considered a noncore business.

In the past year, Ocwen purchased  nonprime mortgage-servicing portfolios from Goldman Sachs, Morgan  Stanley, and Barclays. Its platform now has close to $150 billion of  servicing assets in its portfolio. When the loans default, the business  goes to Altisource. Altisource will probably earn in excess of $5 a  share this year. Ocwen will earn close to $2.50. I think Altisource will  trade in excess of par, and in the fullness of time– i.e., in the next  year or two–Ocwen can go up as much as 50%.

For-profit education is a longstanding short theme for you.

Private education is a very poor value  proposition. There is substantially growing competition from nonprofit  universities that have already begun to tease customers by offering free  courses. Consensus estimates of earnings are dreams that will turn into  nightmares. The stocks have been halved. My largest and favorite short  in for-profit education is Grand Canyon Education   [LOPE]. It trades at $17, and my price target is $8 to $10.

Anything else?

If I want to be long domestic  housing-related stocks like Altisource and Ocwen, it follows that I want  to be short companies exposed to the disarray in Europe and the  prospects for an extended period of slow growth.

The first is American Express    [AXP], which missed in the second quarter. The rate of growth in its  bill business dropped by half in that quarter from the first,  principally because of exposure in Europe. Earnings estimates face a  geographic head wind. There's also a competitive head wind, from  offerings like the JPMorgan Sapphire card. Even Goldman Sachs just  started a consumer bank that will be a competitive threat to American  Express.

The second is Henry Schein    [HSIC], one of the largest distributors of dental equipment, both  consumables and heavy equipment like X-ray machines. It also has a  veterinary business. The valuation is relatively high. I think Henry  Schein will guide lower in the second half because 35% of its revenue  base is non-U.S. Of that, probably 75% is in Europe. It is a serial  acquirer that has made probably 50 acquisitions in the past five years.  Also, I see a more difficult environment for the consumer in the years  ahead as deleveraging continues. A lot of dental expenses are  postponable and discretionary. The stock is virtually at its all-time  high.

Finally, my favorite short of the next  decade is the U.S. bond market, for those that possess deep enough  pockets, have the fortitude and the patience. I am long ProShares UltraShort 20+ Year Treasury    [TBT], which is the inverse, double-short bond ETF. Over the past 2½  years, bonds have achieved a near 60% total return. A remarkable feature  is the consistency of positive returns and the absence of many drawdown  years of consequence. Nevertheless, they should be viewed as a  return-free asset class that is very risky. The 10-year yields under  1.5%, less than half the yield during the recessions in 2001 and 2008.  That means I am paying over 65 times earnings for a 10-year-bond, a rich  price even by Amazon's or LinkedIn's standards.

A taxable investor who buys the 10-year  pays about 40% to Uncle Sam in taxes. So his after-tax yield is 0.9%.  The inflation rate is 2%. So the investor is getting a rather large  negative return. A diminution of the flight to safety is a first  possible disruptive factor.

Other factors that form the basis for  my bond short are that the muddle-through economy might gain speed, that  Fed policy stays on hold, that inflation will ultimately rise, that  housing is embarking on a durable  recovery, that ultimately there will  be a large reallocation of investment out of bonds into stocks, and that  U.S. fiscal imbalances are not being addressed, so bond vigilantes who  will demand higher yields are likely to appear.

Every year, you predict potential surprises for the market. What's the biggest one for the second half?

That Obama wins by a substantial  plurality and that the Democrats regain control of the Senate and don't  have control of the House. The market feels that Romney is far more  pro-market than Obama. In this case, I think you could have a further  drop in valuations, beyond what you might expect from a difficult second  half for corporate profits.

About 70% of the companies that  reported earnings so far have beaten expectations. But 65% have missed  the top line on sales. If the election result means that Congress  becomes more dysfunctional, the market is in big trouble.

Thanks, Doug.

http://online.barrons.com/article/SB50001424053111904599504577544762888954478.html