Veteran fund manager highlights risk lurking in the stock market

A Bulgarian stock market is on a roll, with the S&P 500 hitting 42 record closing highs this year while rising more than 20%.

Some experts believe the party will continue. They cite strong earnings as a factor.

S&P 500 earnings rose 11.3 percent in the second quarter from a year earlier, according to FactSet. While analysts expect expansion to slow to 4.6 percent in the third quarter, that’s still a strong number.

TheStreet Pro columnist Doug Kass, one of the country’s leading investors.

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The Federal Reserve’s rate cut will also help stocks, bulls say, because the cuts boost economic growth, thereby boosting earnings growth.

The Fed cut interest rates by 50 basis points on September 18, and experts expect the central bank to hike another 25 or 50 basis points at its meeting on November 6-7.

In 12 of the Fed’s 14 rate-cutting campaigns since 1929, the S&P 500 posted a positive return 12 months after the initial cuts, according to a Schwab report.

Here is the bear case for stocks

But it’s worth noting that the S&P 500 hasn’t experienced a 10% correction for 288 days (or more than nine months), according to PNC Financial Services. This compares to an average of 172 days (more than five months) between 10% declines since 1928.

The ratings also point to a market correction, pessimists say. As of Sept. 20, the S&P 500 traded at 21.4 times analysts’ earnings estimates for the next 12 months, according to FactSet. This is well above the five-year average of 19.5 and the 10-year average of 18.0.

While much has been said about these risky fundamentals for the market, TheStreet Pro columnist Doug Kass sees a less publicized risk – market structure.

And he should know. Kass has worked as a hedge fund manager since the 1970s, including a stint as director of research for legendary investor Leon Cooperman’s Omega Advisors.

Related: The Veteran Fund Manager Who Correctly Estimated the Outlook for Stocks’ Downgrade

“The markets have become increasingly troubled, both at the bottom and the top,” Kass wrote in a recent column.

“As a result, price movements are exaggerated and some very strange outliers have populated our markets. Think GameStop, AMC Entertainment and most of Cathie Woods’ Ark Innovation ETF portfolio!” Those stocks have risen and then fallen in recent years.

“Inefficiency, wildly overblown stock market action, and investment pain and gain are byproducts of today’s dangerous market structure,” Kass said.

Doug Kass’ concerns about market structure

So what are the structural problems?

1. Passive dominance“The rapid transition from active to passive money management was profound,” Kass said. “Passive strategies account for about 75% of trading volume.”

Passive managers have shortcomings. “They generally know everything about stock prices and nothing about (fundamental) value,” Kass said.

Related: Veteran fund manager finds Warren Buffett’s moves worrisome

Quantitative funds, whose investments are determined by computer algorithms, “know absolutely nothing about Nvidia’s fundamental outlook, but everything about price momentum,” he said.

“And it’s never been discussed that passive strategies are often dramatically leveraged products, which present an obvious risk when momentum shifts and everyone is on the same side of the investing boat.”

2. Grown up crazy: “Social media, meme stocks, message boards, etc. they offered crazy price action,” Kass said. And that action provided more losses than gains, he said.

“The idea that a small group of traders think they are smarter than the entire investor population never ends well. And this phenomenon (read: reckless gambling) continues to emerge.”

Dangers in the middle of options, technology, transparency

1. Speculation on the options has intensified: The proliferation of zero-day-to-expiration options, which now account for the majority of options trading, is another market structure risk, Kass said. Fast expiration can mean very volatile moves for options.

The fund manager buys and sells:

• Experts cite stocks to buy after Fed rate cut
• Cathie Wood exits $23 million in growth tech stocks
• Top Value Fund Manager Says Alphabet Is Deep Value Stock

2. Technological advances raise risks: “Computer-generated investment strategies designed to create a sense of security for retail investors have often backfired in market history,” Kass said.

3. Increased risks of extended transparency: “Today’s transparency has an advantage: it gives instant information to the masses,” which was previously limited to the wealthy, he said.

“The problem with transparency, though, is that some of it is inaccurate.” And that can cause major investment losses.

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