Why hedge-fund manager Doug Kass says his bearish case is now stronger and dip buyers should bide their time

On the heels of a downbeat beginning to the year that saw the S&P 500
SPX,
-1.81%
lose more than 5% and the worst start for the Nasdaq Composite
COMP,
-2.10%
since 2008, February has been slightly kinder, with gains of 1.3% and 1.6%, respectively.

Kass pointed to a “number of recent vintage and market unfriendly developments” that have driven his pessimistic views, such as inflation and interest rates rising into what looks like a slowing economy, as companies struggle to grow profit and revenue amid shortages and price pressures.

He fears the Federal Reserve has this time waited too long to raise interest rates — the later stage of an economic recovery — and risks “causing an accident,” which he thinks will start in the emerging-market debt market.

Kass warned of beastly inflation in the next two years — “valuation and market unfriendly. ” U.S. January consumer price inflation climbed to a hotter-than-expected 7.5% for the year on Thursday, pressuring stocks and sending the 10-year Treasury note yield
TMUBMUSD10Y,
2.032%
to 2% for the first time since 2019.

Read: How there’s been a Greenspan-sized tightening to the economy even before the first Fed hike

Ongoing logistical and supply chain issues will exacerbate the situation, Kass said in the note sent out Tuesday. “Those issues will “not be resolved this year — just go to your local Starbucks
SBUX,
-1.38%
that is closing at 12 noon because of a lack of workers.” Kass noted he was short Starbucks stock.

Kass sees a negative year for stocks and a “normal 15% valuation reset lower,” historically consistent with what happens when the Federal Reserve lifts interest rates by 100 basis points when valuations are elevated.

On that note, he said investors should lower their expectation as many companies — Facebook parent Meta
META,
,
Zoom
ZM,
-2.59%,
DocuSign
DOCU,
-0.73%
and Peloton
PTON,
-3.38%
— saw demand pulled forward during the pandemic, which means tough comparisons are looming.

And retail investors who embraced meme stocks are probably all but finished playing here, while cryptocurrency losses are also potentially a worry for equities as a 50% fall in bitcoin in recent months, for example, could be “damaging psychologically” to the market.

Kass said investors are embarking on a rare event where global bonds are concerned. “There have only been two times in history (1952-53 and 1968-69) that fixed income prices dropped in a two-year period — 2022 will likely be the third time,” he said.

And as “credit anticipates, equities confirm,” he said, noting how the two assets decoupled in the third quarter of 2014 when the Fed issued policy normalization plans. The same happened in the final quarter of 2017, he said.

Another flag has been raised within high-yield debt, he said. “We are always looking for ‘tells’ and early warning signs as to whether the recent market weakness will continue – and a good place to start is the junk bond market, specifically the volatility of that market.” Usually a high reading means wider market distress and the junk bond equity volatility index has moved up sharply since mid-December, he noted.

Read: Junk bond flows have dropped by most since early days of the pandemic

Kass is also worried about a “changed market structure” where exchange-traded funds and quant strategies dominate. “The dangerous change away from active to passive management has led to unprecedented market volatility – with intraday index swings of 2%-3% more commonplace. This sort of backdrop will likely be with us for some time – it does not engender market confidence.”

Finally, the geopolitical picture has also darkened, amid Russia’s standoff with the West over Ukraine, while global economic growth engine China is seeing a slowdown amid a property-price collapse and surging debt.

So in short, be patient bargain shoppers. “As stocks have mounted an abrupt advance over the past week – the relationship between (upside) reward and (downside) risk has deteriorated. Rising equity prices are the enemy of the rational buyer,” he said.