Contrarian Hedge Fund Manager Says The Market Is Overvalued By 12%

hedge-fund-managerDoug Kass is a market timing expert, running the Seabreeze Partners hedge fund from sunny Palm Beach, Florida. He’s also one of the most notable contrarians in the market.

Thus, it’s no surprise that just as the stock market indices are trading at all-time highs, Kass is calling for a market correction. Just a couple weeks ago, the contrarian hedge fund manager said the market is overvalued by 12%.

Over the years, Doug Kass has made some great calls. At the start of 2012 he predicted that the financial sector would outperform the market. As it turns out, the Select Sector Financial SPDR (NYSEARCA: XLF) ETF was up 24% in 2012, outperforming the S&P 500 index’s 11%.

Even more notable is Kass’ track record so far this year. In January, Kass made a number of bold predictions, many of which have either already come true, or are well on their way.

Kass stated that Twitter (NASDQ: TWTR) would fall 70% this year. Shares are already down 50%. Kass also believed that Apple (NASDAQ: AAPL) would trade below $500. That came true just a few weeks after Kass’ prediction.

He also stated that shares of General Motors (NYSE: GM) would trade 20% lower. He was spot on there, and used that as an opportunity to buy shares of the automaker. Another one of Kass’ bolder predications was that shares of major 3D printing companies would be cut in half. The likes of 3D Systems (NYSE: DDD) and ExOne Co (NASDAQ: XONE) are both down just under 50% on the year.

His latest prediction is a bit broader, where he believes there’s a real disconnect between the value and potential earnings growth for the market.

He’s quick to point out that the S&P 500 index was up 30% last year, but S&P 500 earnings only grew 5%. In his recent interview with Barron’s, Kass quoted famed value investor Howard Marks, saying “investing success is not a function of what you buy, but what you pay.”

We actually profiled Howard Marks last month, and noted that Marks is a strong advocate of going against the grain when it comes to investing. Something that Kass is no stranger to. Kass has made a strong case that the market looks pricey at current levels, where the market is being held up by an unsustainable level of quantitative easing. Kass notes:

“With rates at zero, quantitative easing has become a blunt tool. The Federal Reserve has built a bridge to growth, but it can’t deliver the destination on its own.”

This isn’t the first time we’ve heard such a theory.

Billionaire David Einhorn of Greenlight Capital has a similar take on the market. He has likened the Fed’s easy money monetary policy to eating 36 jelly donuts. The first jelly donut gives us an energy boost, but 36 of them is too much of a good thing. He notes that easy money is becoming destructive and actually contributing to the sluggishness of the economy.

Kass has also made the parallel between the tech bubble of the early 2000s to today’s market.

As the tech bubble of the 2000s started to burst, there was a fundamental shift from high tech to value stocks. This same shift has been happening over the last couple months. Again, Einhorn is right there with Kass. In Einhorn and Greenlight Capital’s first quarter letter to hedge fund investors, he notes that “…we are witnessing our second tech bubble in 15 years.” With these kind of predicitons, the market might be overvalued by more than 12%.

Doug Kass’ major short positions:  JPMorgan Chase (NYSE: JPM), Bank of America (NYSE: BAC)

But unlike Einhorn’s Greenlight Capital, which is short a basket of tech names, Kass is negative on a couple big banks, including JPMorgan Chase and Bank of America. Kass says that a market correction will put serious pressure on these big banks.

The items working against the banks includes the fact that benefits of loan-loss provisions have slowed, loan demand is weak (in part, because corporations are already well capitalized), and assuming interest rates/yield curve go against the bank, bank profits from capital-market activity will be weakened.

Doug Kass’ long positions:  General Motors, Ocwen Financial (NYSE: OCN)

Despite his ominous outlook, Kass is positive on a couple stocks, most notably General Motors and Ocwen Financial. Kass is buying General Motors on the recent pullback due to the ignition switch controversy. He’s a big fan of how General Motors is addressing the issues.

Most notably, Kass points to General Motors’ hiring of an attorney that handles high profile incidents, Kenneth Feinberg. The car company has also taken a $1 billion voluntary charge for repairs and other costs.

For Ocwen, it is one of the largest originators and servicers of subprime mortgages. But subprime has changed a lot over the last half decade. The days of no-documentation and “fly by night” loans are gone. Kass’ key thesis is that before the financial crisis, 10% of households in the U.S. qualified for subprime mortgages, but that market has all but dried up today.

In addition, 60% of households qualified for a prime mortgage before the financial crisis, compared to 30% today. So, the subprime market really has to come back in a big way, or else, households will be left renting forever.

Another Doug Kass short is Tesla Motors (NASDAQ: TSLA)

As part of a pair trade, in conjunction with his long position in General Motors, Kass is short Tesla Motors. Kass points to the fact that “Tesla is being capitalized at about $1.2 million a car, versus roughly $10,000 a car for Ford (NYSE: F).”

The speculation that Apple might buy Tesla gave the shares a boost. Now the risky move of building the largest global battery factory is keeping shares artificially elevated. Tesla has to do a lot right to justify its $26 billion market cap.

On the other hand, Kass points to competition from well-established auto manufacturers, hence his long position in General Motors. Kass believes the major automakers’ deep pockets and ability to mass produce gives them an impressive advantage over Tesla.

*****

Kass’ predictions have been pretty well spot on so far this year. His case for an overvalued market is well made. Prudent investors should think about what how a 12% pullback in the market would impact their portfolios. But also, what a market correction would do to major momentum stocks and banks. The pullback in those types of stocks could be much more than 12%.

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Published by Wyatt Investment Research at