Doug Kass, a regular presence in Barron's since 1992 and a longtime student of the markets, brings keen insight, contrarian ideas, and humor to any financial conversation. Kass, 65, is president of Seabreeze Partners Management, an asset manager in Palm Beach, Fla., with several hedge funds. Concerned about stocks' big gains in recent years, he has put a lot more short positions into the firm's portfolios. "Most bull markets end with the emergence of speculative excesses," he says. "Some end with bubbles, and this one could be ending with both." Kass, a prolific pundit and television commentator, has put many of his ideas in Doug Kass on the Market: A Life on TheStreet, a book that John Wiley & Sons plans to publish this fall. Barron's spoke with him recently by telephone.

Barron's: What's your assessment of current stock valuations?

Kass: Prices are high, and values are growing scarce. Warren Buffett, based on the words of Benjamin Graham, teaches us that price is what you pay, and value is what you get. And my buddy Howard Marks, at Oaktree Capital Management, says that investing success is not a function of what you buy—but what you pay. Last year, the S&P 500's earnings were up only about 5% or 6%, but the index advanced by more than 30%. The difference in performance between earnings and investment returns was an outsize increase of 25% in market valuations, as animal spirits were awakened. Since 1990, the average annual increase in the multiple has been 1%. So last year's valuation rise borrowed and has taken away from future market returns.

What's driving stock returns?

Share prices have obviously benefited from massive liquidity and a zero interest-rate policy. The recent high-beta earthquake in which stocks sold off was probably the first shot across the bow. Increasingly, the market seems to be realizing that each progressive quantitative easing is having a more restrained impact on growth. With rates at zero, QE has become a blunt tool. The Federal Reserve has built a bridge to growth, but it can't deliver the destination on its own. And the flattening of the yield curve tells a story of slowing growth. There is about a 230 basis point [2.3 percentage points] spread between two- and 10-year Treasuries, compared with almost 270 bps at the end of last year. That's signaling muted economic growth. If growth fails to emerge in the months ahead, we'll see an ah-ha moment in which investors, to quote the singer Peggy Lee, say, "Is that all there is?"


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"The recent high-beta earthquake in which stocks sold off was probably the first shot across the bow." Doug Kass Photo: Jeffery Salter


What concerns you about projected earnings growth?

The consensus is looking at $120 a share this year for the S&P 500. But these are anything but normal earnings. They are inflated because corporate profit margins are at a 60-year high, and they are 70% above the average of the past six decades. So normalized earnings are well below that estimate of $120 a share, just as normalized earnings back in 2009 were well above the deflated estimate of $45 a share, which was the 12-month trailing number. So the S&P 500 might appear to be trading at only 16 times stated earnings. But against reasonable margin assumptions and normalized earnings, the market is probably trading closer to 19 times. Based on my analyses for different cases for growth, interest rates, and valuations, the S&P's fair market value is about 1650, 12% below where it traded recently.

What concerns you about corporate profit margins?

Corporate profits are the mother's milk of stock prices. First, we've had this lengthy improvement in corporate productivity, and that's likely near complete. We've had years of fixed-cost reductions by corporations, and that's also likely over, because they've cut to the bone. If the employment market gradually tightens, labor costs will rise, pressuring margins. Both interest expenses and effective tax rates will have to rise as central banks normalize monetary policy and the U.S. sees the need to reduce its deficit. And a very costly regulatory policy is likely to continue, increasing corporate costs. And finally, the quiescent capital-spending cycle will ultimately be awakened. With that, amortization and depreciation costs will ascend.

We are in a market with no memory from day to day, sometimes from hour to hour. But we are seeing the rotation that we began to see between 1999 and 2000. Warren Buffett was really out of favor when, during the technology and Internet boom in 1997, '98, and '99, people said he had lost his touch. Value stocks were out of favor and tech stocks were in favor, but then, all of a sudden at the beginning of 2000, you began to see a rotation out of high-beta, high-octane stocks, which eventually collapsed into value stocks. In early 2000, that move presaged a late-2000 considerable decline. So, we are moving from a one-way market to a two-way market where you can make money both long and short. At another important top, in early 2000, the market leadership rotated from high tech to value stocks—exactly what has happened in the past two months. Leadership changes are often the sign of a market correction or bear market.

What in particular will pressure the markets?

Disappointing global economic growth, weaker-than-consensus earnings, and a contraction of the price/earnings multiple, compared with a 25% expansion last year. Those will be the culprits for a negative return this year. The consensus view is missing, among other things, the vulnerability of the middle class, which provides an important source of economic growth. It's missing the economic vulnerability of our young people. It's missing our addiction to low interest rates, both in the public and private sectors. It's missing the consequences of higher rates and the risks to profit margins, probably my biggest concern. And it's missing the widening gap between the haves and have-nots—and the economic and social consequences over time.

You have been long a group of closed-end municipal bond funds. How has that worked out?

The group is up more than 10% this year. My belief at the end of last year was that, contrary to the consensus, rates were going lower. At the end of last year, muni-bond funds were under pressure, owing to concerns about credit quality and rising rates. The yield on the 10-year Treasury went over 3%, and funds were selling at near-record discounts—almost 10%—to net asset values. They were at a near-record tax-equivalent yield, compared to taxable bonds. The discounts are now 6%, but they're still attractive. The funds were under intense year-end selling pressure. Investors had lots of unrealized stock gains and were using them to take losses to pair against gains. My funds include Invesco Pennsylvania Value Municipal Income Trust VPV and Nuveen Quality Income Municipal Fund NQU . By the end of 2014, I suspect, total return will be north of 15%.

Kass' Picks

Recent
Company Ticker Price
Ocwen Financial OCN$38.00
General Motors GM34.17
Monitise MONI.UK66*
...and Pans
JPMorgan Chase JPM56.19
Bank of America BAC16.34
Tesla Motors TSLA207.86
*British pence Source: Bloomberg

Do you still see any opportunities in the stock market?

One of my long holdings is Ocwen Financial [OCN], a leading player in origination and servicing of subprime loans. The nonprime mortgage business is likely to undergo a renaissance. No company is better positioned than Ocwen, the largest player in subprime. Prior to the financial crisis, about 60% of U.S. households could qualify for a prime mortgage, and about 10% could qualify for a subprime mortgage. The remaining 30% were renters. Postcrisis, approximately 30% of households qualify for a prime mortgage, and subprime is almost nonexistent. So unless we're destined to become a nation of renters, something has to change. At the same time, the recent rise in home prices hasn't coincided with income gains for average home buyers. That represents an opportunity for nonprime mortgage companies. Gone are the days of low- and no-documentation nonprime loans. Today, these loans are very secure. The nonprime industry space has been abandoned and created a void for Ocwen.

What about other sectors of the market?

This is a pair trade. I'm short Tesla Motors TSLA [TSLA] and long General Motors GM [GM]. GM's shares have dropped from over $41 at the end of 2013 to $34.17 recently, down nearly 20% since the recall problem stemming from the ignition-switch malfunctions. It is serious, but GM is intelligently addressing its problem. It reminds me of BP's [BP] oil spill a few years ago. That, too, created a major investment opportunity. GM has taken important steps, including hiring Kenneth Feinberg, an accomplished attorney with a history of dealing with these sorts of events. And GM is taking a voluntary charge of more than $1 billion for repairs, warranty costs, and other restructuring charges. These events, although extremely unfortunate, have provided a fantastic entry point for the stock.

What about Tesla? The shares are up 37% this year, though they're down about 20% from their 52-week high of $265, set in February.

My interest in Tesla started out when I found something in the fourth-quarter earnings release and the most recent 10-K. Based on my analysis, the company reduced its warranty reserve by a hefty $10.1 million, a gain that flowed directly into the income statement and boosted margins. The stock rose substantially, providing a great short entry point. Then there were reports of Apple [AAPL] having had discussions with Tesla, allegedly about possibly acquiring it. To me, that was silly. Nothing has come of the rumor. Tesla is being capitalized at about $1.2 million a car, versus roughly $10,000 a car for Ford Motor [F]. A lot of future growth is in Tesla's share price. The narrative has moved to Tesla's plan to build the world's largest battery factory—a risky move. With a market cap of about $26 billion, Tesla has a lot of execution risk and competitive issues. The hope for bulls is that the Gen III vehicle—a lower-priced vehicle [than Tesla's core Model S sedan] to be launched in 2017—will be enormously successful. We think the new Tesla will be hit by pricing pressures from incumbent manufacturers with deep resources, which have demonstrated a willingness to lose money on electric vehicles and have a big head start in mass production.

Moving on, what do you think of the large U.S. banks?

FICC activity, which involves trading of fixed income, currencies, and commodities, has been weaker lately for many of them, including JPMorgan Chase JPM [JPM]. As for credit quality, interest rates, and the yield curve, if all these go in the wrong direction, capital-market activity could be weak. If I'm correct about a market correction, that will put pressure on these banks. Loan demand is tepid and growing slowly, partly because of subpar economic growth and partly because the country's largest companies are very liquid and don't need a lot of credit. Credit quality has improved in the past three or four years, but it's more of a headwind now, as loan-loss provisions start to be less of a benefit. That leads us to interest rates and the slope of the yield curve, by far the most important factor for bank profits; it should be the most worrisome area for bank investors and bank profits. Consider the hedge-fund community's favorite bank, Bank of America  [BAC], which I'm short. Its net interest margin, fell to an adjusted 2.29% in the first quarter, and net interest income around $10 billion was disappointing.

Let's finish up with one more of your ideas.

Monitise MONI.LN  [MONI.UK] is a London company that provides a platform for payments on mobile devices. It trades in London and over the counter in the U.S. [MONIF]. I see this as at least a five-bagger. There is probably no larger business than the mobile-payments industry. This company has a market cap of about $1.2 billion, and could well be one of the most important disrupters in the mobile-payments industry. Visa [V] and Visa Europe own about 13% of it. Monitise just did a private offering in the U.K. at 68 pence [$1.14] a share. The stock is down a little to about 66 pence. MasterCard [MA] has also taken a stake in it. Leon Cooperman, who runs the hedge-fund firm Omega Advisors, has increased his stake to 12% and is the largest shareholder. Monitise, which isn't making money, owing to heavy investment in future growth, has 28 million subscribers. It plans is to have 100 million by 2016, and 200 million by 2018, and it expects fees to go up.


Thanks, Doug.