An Interview with Doug Kass
Hedge fund manager Doug Kass has been called many different names over the course of his storied and successful, nearly forty-year investing career. Names like the "Bear of Boca"; "The Peerless Prognosticator of Palm Beach"; as well as the "Anti-Cramer." He's earned them all. As a noted short seller unafraid to swim against the tide of consensus, he seems to relish his self-appointed role bucking Wall Street groupthink and profiting handsomely from betting against the crowd.
Kass, 59, is founder and president of the firm Seabreeze Partners Management headquartered in Palm Beach, Florida. He launched his career during the Nixon administration as a housing analyst at Kidder, Peabody, and has served in numerous roles ever since then including a position as senior portfolio manager at Omega Advisors, a $6 billion investment partnership, as well as heading institutional equities at First Albany and later, JW Charles/CSG, in the early to mid-1990s. In addition, Kass is currently the principal contributor to TheStreet.com's Real Money Silver website. For more about what he currently sees in the stock market and economy, please read on.
RealClearMarkets: You made a huge, once-in-a-lifetime call when you correctly predicted the stock market bottom back in early March-a generational low as you called it. Equities launched an extraordinary rally on cue with your call, and are up over 60 percent as of this interview. Was this good fortune, or was your call borne out of a repeatable investment process?
Kass: Consider the market as a triangle. The bottom left angle is sentiment and the bottom right angle is valuation. On top is the most consequential angle (the one I weigh most heavily) - the fundamentals.
In March, 2009, sentiment and valuation was clearly stretched to a negative extreme. Investors were fearful of "being in" -- as a result, retail investors and institutional investors (especially of a hedge fund kind) were at record low net invested positions. At the same time, valuation was pushed down to nearly unprecedented low levels vis a vis "normalized" S&P earnings of about $70/share and were trading at a discount to replacement book value (compared to an historic average of about 140% of replacement book value).
In terms of fundamentals, I had a specific Watch List which helped me gain comfort that stocks were creating a Generation Low. I believe, by following this list, that the process is repeatable.
My Watch List indicators were getting "less worse" six months ago - and that a second derivative recovery was well underway, but, at the time, was being ignored as fear reigned.
Here is a partial check list of (ignored) indicators that I was looking at six months ago which led to my adopting a more favorable stock market outlook:
• Bank balance sheets were being recapitalized.
• Bank lending was slowly being restored as the industry was experiencing record wide net interest spreads and margins.
• Financial stocks' performance was improving.
• Commodity prices were beginning to rise- a sign that worldwide economic growth was mending.
• Credit spreads and credit availability were slowly improving.
• With affordability at record levels, the cost of home ownership versus renting becoming more favorable and with the Federal Reserve providing a low interest backdrop - a bottom in the housing markets was growing more likely.
• Corporations' draconian cost cutting was accelerating - sowing the seeds for upside margin and earnings surprise in 2009's second half.
• Corporations had cut inventories to the bone - a record low level of inventory to sales augured positively for corporate profits.
• There was growing evidence of favorable reactions to disappointing earnings and weak guidance - a sign that the poor operating environment had been discounted.
• Evidence of strength in China's economy (two consecutive months of a rising PMI) and in its equity market (seen in strong absolute and relative strength in Chinese stock market.
• Market volatility was starting to decline.
• Hedge fund and mutual fund redemptions were easing.
• Pension funds were far too skewed towards fixed income and provided the potential to buoy stocks in a reallocation in the months ahead.
RCM: PIMCO's Bill Gross recently wrote that America's "Consumer Cuisinart consumption is a relic of the past." He added that, "Greed will come again. But for now, the trend is the other way and it promises to persist for a generation at a minimum." Do you agree with Gross's assessment? Is it a done deal that U.S. consumers will save more and consume less for an entire generation?
Kass: I agree with Bill Gross that the strongest economic headwind to growth over the next few years is the consumer. After decades of aspirational spending, the consumer is likely moving back towards the post Depression legacy of trying to maintain their status quo.
Working against the consumer is not only the material erosion in household wealth, but it may be seen in a structural shift towards higher employment - the demographic force of maturing baby boomers will hurt personal consumption spending, individuals are being forced to work more years and corporations will likely retain a tight rein on employment (vs. prior cycles).
Further exacerbating the pressure on the consumer will be the inevitable inflation in commodity prices, higher interest rates and continued wage deflation (owing to globalization). This phenomenon was clear as day in Wednesday's Philly Fed release, which showed that prices paid was way up and prices received way down.
RCM: Has the psychological trauma experienced by Americans over the last year or so been underestimated? And what will the dent in the American psyche mean for the economy in the years to come?
Kass: The points I made above on the consumer are crucial to my double-dip thesis and for now, in my view, are being lost in the bull dialogue. But there are other nontraditional headwinds that will undermine economic growth:
1. Deep cost cuts have been mainstay of corporations over the last few years. Cost cuts are a corporate lifeline (like fiscal stimulus), but both have a defined and limited life. Ultimately, top-line growth is needed.
2. Cost cuts (exacerbated by wage deflation) pose an enduring threat to the labor force. The consumer remains the most significant contributor to domestic growth. Unemployment should remain high, exacerbated by many retiring later in life because their nest eggs have been reduced.
3. The consumer entered the current downcycle exposed and levered to the hilt, and net worth (and confidence) has been damaged and will need to be repaired through time and by higher savings and lower consumption. (The consumer is hurting. Last week I met with a midsized bank's lending team. The bank is seeing a big mix change toward rising use of their debit cards (where money is in the bank) at the expense of credit cards (where money is then owed).)
4. The credit aftershock will continue to haunt the economy. The unregulated shadow banking industry is dead, as is the securitization market. All signs indicate that banks will likely remain reluctant to lend to individuals and small businesses. Just try to get a jumbo mortgage today!
5. The effect of the Fed's monetarist experiment and its impact on investing and spending still remain uncertain.
6. While the housing market has stabilized, its recovery will be probably remain muted. (My view was supported by last week's housing starts release). More important, there are few growth drivers to replace the important role taken by the real estate markets in the prior upturn.
7. Commercial real estate has only begun to enter a cyclical downturn. It might not be as deep as many expect, but it won't provide much of a contribution to growth.
8. While the public-works component of public policy is a stimulant, the impact might be more muted than is generally recognized. There may be less than meets the eye -- most of the current fiscal policy initiatives represent transfer payments that have a negative multiplier and create work disincentives.
9. Municipalities have historically provided economic stability during times of economic weakness -- no more. They are broadly in disrepair. State sales taxes are being raised all over the country, and so are sin taxes (to shore up municipal finances) on cigarettes, booze and maybe even sugar products.
10. The most important nontraditional headwind is the inevitability of higher marginal tax rates. How will higher individual tax rates affect an already deflated consumer? How will corporations react to higher tax rates? Will rising taxes be P/E multiple benders?
RCM: In August, you put your bear hat on once again, and began predicting a market pullback. You wrote that, "The effect of the Fed's monetarist experiment and its impact on investing and spending still remain uncertain." And yet the stock market surge has been sustained, while signs of the recession's end have accumulated. Did you underestimate the power of a very-easy-money Federal Reserve? Or is there something else at play?
Kass: It is important to emphasize that my bullish thesis in March was coupled with the view that a sharp upwards move in stocks, towards the S&P Index level of about 1050, would terminate in the fall as it became evident that a number of nontraditional headwinds would emerge and render a self sustaining economic recovery doubtful. Maybe more than anything, George Soros's Theory of Reflexivity could help to explain both the extreme low in March, and, arguably the extreme move made recently. Reflexivity is a theory that says moves are excessive in both directions as the behavior of market participants tends to exacerbate those moves to a point where it becomes excessive and ultimately reverts back and regresses towards the mean.
It is clear that the liquidity that grew out of the massive government stimulation and the growth in the monetary base is reaching the equity market and our economy. Surprisingly (at least to me) it has been greeted by almost unnoticeable, brief and shallow pullbacks in stocks -- producing a degree of price momentum reminiscent of the "good old days" in 1999. You might say that the fear of "being in" back in March has been replaced by the fear of "being out."
If value is in the eyes of the beholder, I need glasses -- the recent surge in sentiment and in share prices has left me out in the cold. As I said previously, my bearish thesis has been that investors would look through the "statistical" domestic recovery in the improving earnings cycle and in the temporary or artificiality of the numerous stimulus policies (that we're borrowing from 2010), and look ahead at the nontraditional headwinds that pose a threat or at least a degree of uncertainty in a self-sustaining recovery outcome.
Many market participants appear to be growing increasingly comfortable with the certainty of a self-sustaining recovery. Possible ... but in my view we face a broad array of consequences (some good, some not so good!) in 2010-11.
A week ago, CNBC has a town hall meeting with the Treasury Secretary which reinforced that heavy lifting lies ahead and that the outcomes are uncertain. As Timothy Geithner emphasized, the easy part of bringing the system back from the abyss has been accomplished, but "recovery and repair" will take time and will at times produce "uneven" results.
My baseline expectation - that most investors, for now, apparently don't share - is that corporate managers and investment managers face an extended period of lumpy and uneven growth. It will be a difficult playing field to navigate. The nontraditional headwinds discussed in the previous question will weigh on the domestic economy in the years ahead.
As much fun it is making money in a down market (read 2008 and early 2009), it's admittedly discomforting not to be participating in a ramp like we have witnessed. For whatever reason, stocks are marching higher as investors are impervious to merchandise that grows more expensive as the year passes. I pride myself, unlike my perception of some "talking heads," as being honest. When I am wrong in my market/economic/stock judgments and opinions, I confess.
I was dead right in my variant call for a Generational Low in the first week of March. But, confiteor and mea culpa ... I have been caught flat-footed and dead wrong in my recent call for a market top. That said, while I might feel stupid, I do not feel pressured in managing other people's money by committing aggressively to an asset class (like stocks) because that class is on a tear. Rather I will always seek "value" at an attractive price.
RCM: If President Kass were in the White House, would he spend the remaining stimulus money? If yes, where would he spend it? If no, why?
Kass: I would abandon all stimulus now - before it is too late and the consequences of the massive monetary and fiscal Reflation Experiment of 2009 begin to appear. From here, I would let the economy and the markets do what they will do.
RCM: While we're on the subject of presidents, you were, as I recall, an Obama supporter. Any buyer's remorse?
Kass: I supported President Obama and continue to do so.
I suppose the proof is in the pudding - and the pudding (the stock market's performance since the President's inauguration) has reflected, in part, the implementation of superior and proactive policy and investors' confidence in our leadership. From my perch, the current administration -- unlike the previous one -- is engaged in thoughtful dialogue and is dominated by highly qualified policy makers.
I just hope they don't go overboard in policy.
RCM: Are there any domestic or international "X-factor" issues on your radar screen right now, developments that investors will want to track?
Kass: Over there, I remain fearful of geopolitical risk. I wonder whether we have grown too complacent.
Over here, I am reminded of something said by Berkshire Hathaway's Charlie Munger recently: "In poker terms, the Treasury and Fed have gone "all in." Economic medicine that was previously meted out by the cupful (pumping dollars into the economy) has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone's guess, though one likely consequence is an onslaught of inflation."
I believe that the challenges and the bills associated with massive policy actions aimed at combating unprecedented economic/credit market problems are being ignored -- or investors believe they can get out before they come due.
RCM: Time travel 20 years forward to 2029. Where does America stand in the global pecking order? Should Americans today be hopeful or worried? Should my kids learn how to speak Chinese?
Kass: I am reminded of a Chinese Proverb: "A rat who gnaws at a cat's tail invites destruction."
Like Blanche DuBois in A Street Car Named Desire, the U.S. has relied on the kindness of strangers to fund our economic growth. As Blanche said, "Oh look, we have created enchantment."
But for how much longer?
After years of greatness, the U.S. is destined for not so greatness.