Still Bearish

The majority of analysts are still bearish on the financial sector.  Thomas Brown makes very strong arguments in countering Merrill’s analyst team’s reasons why they believe the rally in financial stocks is unsustainable.  Tom goes even further, he believes July marked the end of a bear market and the beginning of a new bull market.  Courtesy of Thomas Brown, Bankstocks.com.

Surprise! Street Still Bearish On The Financials

After I wrote here last month that July 15 would likely turn out to be the bottom for the financial stocks, I’ve been encouraged, believe it nor not, that the vast majority of industry analysts disagree. They see the stocks’ rally as just a bounce in a bear market that will never end. If anything, the bears are more bearish than ever.

Not to mention more popular. Have you read the ode to Meredith Whitney in the upcoming Fortune? It runs 4,200 words and includes the sorts of details that might turn up in a People magazine profile of Angelina Jolie. (“She recently gave up coffee, and she works out twice a day, often under the supervision of rapper 50 Cent’s personal trainer . . . ”) And, yes, it’s the cover story. You will have your own view as to when the turn in the financials will happen, but you’ll have a tough time denying that this is the exactly the sort of financial journalism that only gets published near market extremes.

(And, as I say, maybe the extreme has already passed. Wachovia’s stock, for example, has jumped by around 90% since Whitney downgraded it to underperform three weeks ago.)

Then there is the note the banking team at Merrill Lynch published earlier this week: “No reason to turn positive past 2Q earnings season.” It is the picture of rear-view-mirror analysis—and typical of what’s being turned out by the sell-side these days.

“We will see another 28% downside risk for the group,” they write. Don’t you love that precision?  Actually, a 28% decline in the stock prices of the names in their universe wouldn’t take the stocks’ prices meaningfully lower than they’ve already been. Maybe Merrill is calling a bottom, too, but just doesn’t realize it.

The Merrill team then lists three reasons why it believes the recent rally is unsustainable. None are convincing, in my view: 

1. “Stocks won’t bottom until problem loans peak, and we are a long way from these levels.” In fact, the Merrill crew has things precisely backwards. In the bear market of the early 1990s, problem loans didn’t stop rising until nearly a year after the financials bottomed in November of 1991. The Merrill analysts shouldn’t be looking at the absolute level of problem loans, but rather the rate at which problem loans are rising—the so-called “second derivative.” And on that score, the news is encouraging. At one company after another last quarter, the rate of inflows of new problem loans declined, even as companies larded on big additions to their loss reserves. That’s what the beginnings of a fundamental turn looks like. Yet the stocks’ valuations’ seem to be discounting a credit crackup that will last more or less forever.
   
2. “Valuations are still high compared to historical average and current returns.” Valuations high compared to “current returns”? By that standard, Merrill Lynch won’t turn positive until investors get paid to own the stocks. With respect to their first point—that valuations are high versus the historical average—much is lately being made of the fact that banks’ price-to-book ratios are still meaningfully higher than they were at the lows of 1990. Take a look at table below, and you’ll see:

3. “The group will unlikely bottom until historically high volatility subsides.” The Merrill analysts don’t exactly define what they mean by a “bottom” here. Is it when the stock prices hit their absolute lows (which is my definition and, I presume, everyone else’s), or is it when Merrill Lynch’s analysts finally sound the all-clear?

   Regardless, the Merrill analysts must surely know that stock price volatility is often at its highest at precisely the moment of market turns. (August, 1982 is perhaps the mother of all examples of this phenomenon; this past July 15 saw heavy volatility, as well.) Combine the extremely depressed valuations of financial stocks with the high short interest in them, and I don’t see how the turn can’t be accompanied by huge volatility. Of course, once people realize the turn has happened, volatility will be seen as a good thing, not a bad thing, and Merrill’s analysts won’t be so eager for it to go away.

Concerns

In their report the Merrill analysts raises three other concerns about bank stocks: a) earnings expectations are too high, b) credit will continue to worsen, and c) capital concerns will increase.

With respect to earnings and credit quality, those were lagging indicators the last credit cycle and I expect them to be so again this time, too. The market is forward-looking; at inflection points, it doesn’t much care how last quarter’s earnings or chargeoffs turned out.

As to the concern that possible future capital raises might somehow become more difficult because participants in prior raises are now underwater, somebody please buy these people a newspaper. Their own firm just raised $8.5 billion at $22.50 per share after raising $12.8 billion in December and January months at at around $48 per share. So yes, it can be done, and without too much trouble, either.

Reasons to be Positive

As I say, I believe the bear market in financials ended on July 15^th. That doesn’t mean every day from now on, the price of every financial will move up. But I do believe that, in aggregate, the lows in financial stock prices have been reached.

Unlike Meredith Whitney and the crew at Merrill Lynch, I’m optimistic because:

1. The rate of credit deterioration has slowed, as measured by the inflows of new problem loans.
   
2. Lenders are aggressively charging off loans and adding to their loss reserves.
   
3. “Core” earnings power has been maintained at most institutions, and even enhanced at some.
   
4. Company stock valuations reflect a dramatically more severe and prolonged economic downturn than is consistent with most economic forecasts.

The consensus of analysts and the media is that the bounce in financial stocks since July 15^th is just that: a bounce.  I believe it’s the end of a bear market and the beginning of a bull market. It’s time to buy the stocks.

What do you think? Let me know!