Seabreeze's Kass: Bank stocks "priced to perfection"

NEW YORK (Reuters) - Hedge fund manager Doug Kass said he is selectively shorting U.S. financial stocks, which have more than doubled since bottoming in early March, on the belief that they have been "priced to perfection" ahead of the banks' stress test results later on Thursday.

"From my perch, investors should sober up and reduce their holdings in financials now," Kass said in a note to clients. "Financial stocks are now priced to perfection."

The KBW Bank Index of 24 large lenders, including 14 that are subject to the stress tests, jumped 25.8 percent in the first three days of this week and had more than doubled since bottoming on March 6.

However, it was down more than 5.2 percent on Thursday afternoon, awaiting the release of so-called bank stress-test results that are expected to force some banks to raise billions of dollars in capital.

In a follow-up interview with Reuters, Kass said: "I am legging into some shorts -- selectively." Kass is founder and president of Seabreeze Partners Management.

In a short sale, investors borrow shares and sell them, betting that the stock price will fall. The goal is to buy the shares back at a lower price, allowing the investor to return the shares to the broker while taking a profit on the spread between the original sale price and the cost of buying the shares back.

Kass argued that the overshoot to the downside through early March has now morphed into a frenzied buying stampede and "pricing disequilibrium" that is ignoring several factors.

Those include the damage to the banking industry's balance sheets, a continuing negative loan-loss cycle and the reduced earnings power of the industry, he said.

A series of dilutive capital raises has served -- and in the future will likely continue to serve -- to reduce the earnings power of many financial institutions, both from the standpoint of higher interest expenses and more shares outstanding, Kass said.

"Many financial institutions have jettisoned profitable businesses in order to replace the lost capital from the drain of toxic assets, serving to permanently cripple earnings power," he said. "While there has been second derivative improvement, there is growing evidence that the consumer loan-loss cycle will weigh on banking profits for years to come."

Kass said the commercial or non-residential real estate downturn is only beginning to be felt on banking industry profits. "It, too, will be a drag on earnings for several more years," he said.

Forward earnings power will be limited, owing to government restrictions on a reduced ability to lever up capital bases as well as a more moribund capital market in 2009-11, he said.

"The banking industry, more than nearly any other market sector, is exposed to a possible double-dip in the U.S. economy in late 2009-early 2010," Kass said. "Even if the economy does not double-dip, my baseline expectation of an uneven, lumpy and inconsistent economy over the next three years will prove hard for the financial industry to navigate in."