Questioning Doug Kass's Investment Philosophy

 |  Includes: CSCO, INTC, MSFT, ORCL, SPY, XLK
by: Brian McMorris

Doug Kass penned another column on Thursday (The Flip Side) that casts doubt on the stock market and economic recovery. Kass was at one time someone I followed very closely, as he offered alternative viewpoints that anticipated market direction. But lately, I have disregarded his commentary. I am not sure how those who invest in his funds are making any money. Kass is way off the mark.

The problem for Kass is that he has lost his credibility. He went negative in May 2009. That is almost a year, and 300 S&P 500 points ago. I am sorry for him. He had been nimble in the past and able to acknowledge a bullish market situation when it appeared. But now he is becoming a perma-bear, who will keep saying the same thing till he is right. Those guys are dangerous to listen to because they take people out of the market at the wrong time. Anyone following Kass has missed a 30% move in the market.

The key for me in investing is staying covered/hedged. The mistake I made in 2008 is that I did not cover up. I used a few covered calls, but did not buy a portfolio put. Now I am doing that and covering almost 50% of my total portfolio with a short position, using an Out-of-the-money put on the SPY. It won't pay off in a small 3-5% profit-taking correction, but will if the bottom falls out.

Bears like Kass are claiming that Sentiment is frothy. There might be some indicators that show this, such as the AAII survey, which is nearing a high in Bull versus Bear consensus at 42.9%. Other surveys show similar results. But these surveys are among professional investors. The retail investor has remained mostly on the sideline. We are no where near a cyclical market top, though a short-term correction is likely due.

Sentiment is only one element of market forecasting. Technicals and fundamentals are also very important. Even if the sentiment is overbought right now, that can go on for months or years as it did in the mid '90s and the 2003-07 period. Technicals are the same, they only tell part of the story. The wedges/flags now forming in the broad market indexes will look completely different if there is a 3% correction to move down the near term lows. Then the pattern becomes a channel of support, not a bear flag.

But most important are fundamentals. If earnings on Oracle (NYSE:ORCL), Cisco (NASDAQ:CSCO), Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC) continue strengthening during the year, they are trading now at less than 12X the next 12 months. That is ridiculously low for stocks with 70% plus gross margins that throw off tons of cash and should probably trade for 25X or more in this low interest rate environment. I think the Tech Indexes, like XLK, can double over the next 12 months, just on the fundamentals.

I still like the moving averages as a very good technical indicator and easy to understand. The 21 day on the SP500 is at 1177. That would be the first line of defense (about 3% below the current level). The 100 day is at 1100 and the 200 day is at 1050 (it held at exactly the 200 day average in early February when it was at 1020). The only way to break through the 200 day moving average is a major economic train wreck. That won't happen the remainder of 2010 with the momentum we have right now.

If I had used the 200 day avearge more religiously in the past (and maintained my put protection), I would have been out of the market in December 2007 when the market broke below S&P 500 @ 1500. That turns out to have been very good timing based just on that one strong indicator. The break could happen in 2011 or 2012 if the government jacks taxes or the Fed jacks interest rates too high. But I don't think either of those will happen (at least as of today). I think we go 4-5 years now, with a strong global economy and some political moderation. November will tell that story. Eventually, global economic growth will become too strong and unstable, and then we will have a 20% plus bear market correction. But that might be 2014 with the S&P 500 at 2000.

So, I would say be very careful about being too bearish. That is the high risk position in my mind. We can lose the best years of our investing career going into retirement age.

Disclosure: Author long and short calls on MSFT, INTC, XLK, CSCO and long puts on SPY