September 3, 2007
The Problem with Financials
Barron's this week ran an article “Few Bears Here – Why Top Strategists Remain Bullish on Stocks Well Into 2008,” adding “even the most cautious have penciled in hardly any downside for stocks.” The main reason for this optimism is a widespread optimism about upcoming earnings. Evidently, it is not important to Wall Street strategists that there is literally zero correlation between year-over-year changes in earnings and year-over-year changes in stock prices (much less quarter-over-quarter changes). In any event, far from the notion that the tone of Wall Street is terrifically bearish here, the tone on Wall Street remains quite upbeat, albeit slightly less so than at the late-1972 early-1973 market peak, when Barron's ran a similar article, titled “Not a Bear Among Them.”
For my part, I generally decline requests to participate in such surveys, for the basic reason that I don't believe it's possible or useful to make short-term market forecasts. Still, that doesn't mean that we approach the market with no information or expectations at all. It's certainly necessary to consider economic conditions and risks, so we don't leave ourselves open to predictable events such as rising mortgage and credit defaults. And market conditions provide a great deal of useful information about the probable average return/risk profile of the stock market, if not precise forecasts about any specific instance. Finally, valuations generally provide a powerful basis for long-term (7-10 years and beyond) projections of total returns. What I don't do, however, is make forecasts about where the market is going this week, or this month, or by year-end, and base our investment positions on those short-term forecasts.
From my perspective, the Market Climate we observe next week might be different than what we observe today (particularly in terms of the quality of market action). Meanwhile, whatever small positive or negative “expected return” we might project for the coming week is simply overwhelmed by random noise. Taken together, those two facts mean that it is impossible to form meaningful expectations about short-term market direction – a one-week “forecast” is statistically meaningless, and projections beyond one week assume that we know the future sequence of Market Climates that will be observed.
Even so, over the full market cycle, it turns out to be quite enough to align ourselves with the average return/risk profile associated with the prevailing Market Climate. As the Buddha taught, the future will simply be an unfolded path of present moments. If we take good care of the present moment, we take good care of the future.
[The hard-nosed explanation of all of this is that the statistical significance of the expected return/risk ratio increases by the square root of the number of periods included in the sample, so even if the one-week return/risk ratio is statistically insignificant, the full cycle return/risk ratio can be excellent. Personally, I prefer the more poetic explanation of why we stay grounded in the present moment.]
The problem with financials
We continue to carry a very low weight in financial stocks. Though the recent weakness in these stocks has prompted a great deal of interest in “bottom fishing,” my impression is that such efforts are based on the same untempered assumptions of high and growing earnings in this sector that existed months ago. P/E ratios ought to be well below historical norms when those P/Es are based on record earnings and record profit margins. In my view, existing valuations are based on untenable assumptions of permanently high profit margins in this sector, with optimistic growth assumptions as well.
In 2000, this was the essential problem with the technology sector. It was some time before Wall Street's expectations caught up with the reality that profit margins are cyclical and that early declines off of overvalued peaks do not constitute bargains. I expect that in the next year or two, we will observe at least one quarter, and more likely a full year, in which the entire profit of the U.S. banking sector is consumed by loan losses.
Consider, for example, the latest FDIC Banking Profile, which was published based on June 30, 2007 data (before the recent liquidity crisis emerged). In that report, the FDIC noted that the ratio of loan loss reserves to total loans remains at a 32 year low. As for the portion of those loans that are in trouble, the FDIC notes “for the fifth quarter in a row, reserves failed to keep pace with the increase in non-current loans.” The industry's “coverage ratio” of reserves to non-current loans fell to the lowest level since the third quarter of 2002, while non-current loans posted the largest quarterly increase since the fourth quarter of 1990. Recall that 1990 and 2002 were periods when recessions were already well underway. If we're already seeing these signs of credit stress at the peak of an economic expansion, the figures we observe in a recession are likely to be a lot worse.
James Grant put it this way – “Benjamin Graham and David L. Dodd, in the 1940 edition of their seminal volume ‘Security Analysis,' held that the acid test of a bond or a mortgage issuer is its ability to discharge its financial obligations ‘under conditions of depression rather than prosperity.' Today's mortgage market can't seem to weather prosperity.”
As of June 30, 2007, the net income of all FDIC insured banking institutions totaled $36.8 billion. At an annual rate, that represents about 2% of all loans outstanding. Meanwhile, net charge-offs for bad loans were already running at an annual rate of about 0.50% in June. That's in a strong economy, before the recent problems, and loan loss reserves didn't even budge from a 32-year low. Net charge offs could easily quadruple in a mild recession.
Importantly, the problems go far beyond sub-prime. In its June 30 report, the FDIC noted “all of the major loan categories posted both increased net charge offs and higher net charge off rates.” Overall, net charge-offs jumped by over 50% from year-ago levels, with a jump of over 60% for consumer loans and over 70% for industrial loans. These percentage jumps are so high because they are off of such a low base, which underscores the extent to which observed profits in the financial sector have been unhindered by loan losses in recent years. Charge-off rates have not soared as much for credit cards, but this is because the existing level of charge-offs is already high (representing over 3% of the total amount volume of credit card balances, year-to-date). In short, the problems are in all categories, and given the thin coverage of the banking system for such losses, rising charge-offs and loan loss reserves are likely to bite deeply into earnings.
For some financials, relatively high dividend yields are being touted as a measure of safety and quality for investors. The difficulty is that if earnings come under pressure, a greater share of earnings will be required to cover those dividends. Of course, the long-term return is equal to the dividend yield plus the long-term growth rate of dividends. Though I don't expect forced dividend reductions for major U.S. bank stocks, I do believe that the growth rates assumed by Wall Street here are overstated. And while a well-covered dividend can produce a lower “duration” and therefore a smaller sensitivity to broad market fluctuations, it does not in itself produce an undervalued stock.
Historically, strong buying points for financial stocks have generally occurred when the group has traded at about book value. Currently, the typical multiples are two and often three times that level. That isn't to imply that financials must retreat to those lower valuations in this instance, but it's important to recognize that many financials are only “cheap” based on comparisons with very recent norms, and on the assumption that the high profitability levels of recent years will be sustained indefinitely.
In any event, my impression is that the problems for financials are just beginning, and that the risk premiums demanded by investors are likely to rise. As investors have seen throughout market history, stocks having rich valuations, weakening fundamentals, and rising risk premiums typically don't constitute great bargains.
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. The market has now cleared the oversold condition that we observed several weeks ago, yet breadth and trading volume have not evidenced the strength and persistence that we typically associate with more sustained recoveries from oversold conditions. That's not to say that we can't observe further market strength, but at present, we have no evidence either from valuations or from market action to reliably speculate on such strength. Accordingly the Strategic Growth Fund remains fully hedged at present – the Fund is fully invested in a broadly diversified portfolio of individual stocks, with an offsetting short position in the S&P 500 and Russell 2000 indices in order to mute the impact of market fluctuations. Provided that our long-put/short-call index option combinations have identical strike prices and expirations, the returns in such a position are driven primarily by the difference in performance between the stocks held by the Fund and the indices it uses to hedge. Including reinvested distributions, both the Strategic Growth Fund and Strategic Total Return Fund ended last week at all-time highs.
In bonds, the Market Climate was characterized last week by unfavorable valuations and favorable market action. As I've frequently noted, the expected return/risk profile of bonds, even over shorter horizons, is more heavily influenced by the level of yields than by the prevailing trend (which can reverse abruptly when yield levels are particularly low or high). While the yield curve has normalized slightly, it is certainly not steep by any historical measure. Neither are yields particularly high relative to probable inflation. And as I've noted before, “buy signals” from the Fed Model when yield levels are generally low tend to have no correlation with subsequent stock market returns but are often followed by substantial weakness in bond prices.
At the short-end of the curve, prevailing Treasury bill yields are also not significantly above inflation, but are already substantially below the prevailing Federal Funds rate. This suggests that any Fed rate cuts will do little but align the Fed Funds rate with existing market rates at short maturities, and may not have much impact in driving market rates lower. An explosion in near-term credit concerns could certainly drive market rates lower across the maturity spectrum, but with the bond market generally overbought, that possibility is not sufficient to establish a speculative exposure. Overall then, an opportunity to increase our portfolio durations will probably emerge only after some amount of weakness (rising yields) at the long-end of the maturity spectrum. Meanwhile, the Strategic Total Return Fund continues to carry a duration of about 2 years, mostly in Treasury inflation protected securities.
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