On the U.S. side, in mid-July the markets concluded that Freddie Mac and Fannie Mae are going under, which is bad, but that the government will guarantee their bonds in order to prevent a financial catastrophe. The bonds of these heavily leveraged mortgage guarantors still trade at a modest premium to Treasury bonds. Shareholders of those two companies, however, have lost about $100 billion in market capitalization. The fact that the U.S. printing presses do, in fact, back the bonds is important because ownership of the bonds is spread throughout the banking sector and were the bonds to fall precipitously the banking sector’s “mark-to-market” accounting rules would mean a lot more banks would fall into the “troubled” category.
Major market players, (Bill Gross for example) are on record as saying that the Fed needs to take these entities over, sooner rather than later, before the mortgage market can return to any semblance of normalcy. In the meantime, Gross is trying to buy $5 billion worth of mortgage-backed securities which will likely rise in value once the spread between mortgages and treasury bonds narrow. He’s saying in effect that the Fed needs to step in to prevent a “financial tsunami” from spiraling out of control, but he’s not so pessimistic that he isn’t willing to step into the middle of the fray and buy distressed mortgage assets. Color him concerned, but not pessimistic.
I share both his concern and his underlying optimism about the U.S. financials sector. There is more bad news to come. California foreclosures continue to soar, though other parts of the country are starting to see foreclosure rates decline. To me, the financial sector may have bottomed, but its not going to lead us out of the slump.
From July 15 to September 4, the financials and consumer cyclical stocks have been appreciating while most sectors, and especially the energy/commodity complex, has experienced a ferocious sell-off. Why the divergence?
I think that the energy and international stocks are experiencing double-digit declines (since July 15) as investors worry that the U.S. recession is getting worse and spreading to the global economy. Though I don’t think a global recession is in the cards, what worries me most is that the market seems to be signaling this outcome. Our international investments, once more than 40% of our mutual fund portfolio model, have been systematically sold to the point where now it is almost down to 5% of the total portfolio. The fund strategies still have about 30% invested in the bond market. Outside of the consumer staples industry, it’s increasingly difficult to find any asset class anywhere that it working.
The last few months have this market feeling a bit more like 2002. Back in 2001, it wasn’t that hard to make money, even in a declining market. Simply by not owning technology, portfolio managers could dramatically outperform and it wasn’t that hard to find sectors with positive returns that year. In 2002, though, it was difficult to find anything that went up, with bonds and real estate being major exceptions to the rule. By the end of August, 2008, the market looked a lot more like 2002 in that it’s becoming increasingly harder to find any asset class going up.
As investors, consumers, and financial institutions de-leverage (reduce their level of borrowing), they are forced to sell assets to reduce the size of their balance sheet. Even strong asset classes are put on sale. At the end of the de-leveraging process is a great time to buy. The questions is, are we near the end?
The financials say yes, but keep in mind that a year ago the financials were saying that the sub-prime crisis would cost, at the most, maybe $10 billion. In reality, that estimate didn’t even cover half of what a number of the large banks ultimately had to write off. In my book, the financial market has no credibility as a forecaster. Though I do believe that mid-July might represent a bottom, and that by now most of the financial sector write-offs are already factored into current market prices, that doesn’t mean that the financials are a timely place to invest, or that they can lead the market up from here. It will take time for managements to re-gain earnings power and credibility. The write-offs aren’t over, but they will no longer come as a surprise.
The commodity and global markets are saying that the recession will spread as the de-leveraging continues. Fear has certainly replaced confidence in those markets. The steep declines are reminiscent of 2006, though, when Amaranth Advisors held a distress sale of billions of dollars worth of energy assets. I think that some over-leveraged hedge fund shops are being forced to sell assets. Once those funds have liquidated their books, hopefully the commodity markets will at least stabilize.
The signal we’re waiting for is for strength in the U.S. business sector, especially in the consumer cyclicals, industrials, technology and healthcare sectors. When these sectors start leading the market up, that will be a sustainable rally. The earnings power in these sectors remains intact, while the financials have diluted their earnings power because they’ve been forced to raise capital at a difficult time in the market. Even highly regarded Wells Fargo just completed a preferred stock offering that pays investors 9.75% in order to go out and make more mortgage loans that pay back 6.5%. These are tough times for banks, and forward earnings estimates have zero credibility at the moment. It’s hard to have a sustainable rally until we move beyond the current real estate bust. It’s hard to say that the sector is valued at an attractive level when book value keeps shrinking, dividend yields are being cut in half, and an earnings recovery is based on assumptions that have no evidence of being accurate.
Our fund portfolios are sitting on the fence, still defensively positioned in bonds while recently adding pro-recovery sectors like healthcare and technology. Intellectually, I’m fairly optimistic that consumer confidence will return, the recent spate of layoffs will be absorbed into a reasonably healthy manufacturing sector, and eventually stocks will rally because investors aren’t finding attractive returns in cash, bonds, or real estate investments.
Unfortunately, we can’t look to economists for an answer. They put out a lot of useful statistics, but by the time they declare that we’re in a recession, it will already be over. Portfolio managers have to make decisions before all of the economic data is in. Once the recovery has been established beyond all reasonable doubt, prices will be much higher than they are today.
Being a portfolio manager is the most interesting job in the world and it’s a lot like being an economist – except that you have actual responsibilities….
WARNING: Stolen joke alert – (Q) Did you hear of the economist who dove into his swimming pool and broke his neck? (A) He forgot to seasonally adjust his pool.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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