|
US stocks
to open down 2-3% on news of Lehman bankruptcy
Stock futures
reacted poorly to the news that Lehman would not be purchased either by
Barclays Bank or Bank of America and would instead enter bankruptcy. In a surprise development, Bank of
America announced instead that it would purchase Merrill Lynch. Investors had hoped that the US
Treasury would enable the sale of Lehman by guaranteeing a certain level
of losses. In March, the sale of
Bear Stearns to JP Morgan was facilitated by a $29 billion guarantee. However, the Treasury apparently felt
that the risk of a Lehman bankruptcy was not the same as Bear Stearns, so
elected not to provide the guarantee.
Lehman,
Merrill Lynch follow Fannie Mae, Freddie Mac into History Books
How could these
firms, with histories running back 153 years in the case of Lehman, all
disappear in under a week? Like
many hedge funds that disappeared in recent weeks, these firms followed
the "aggressively leveraged one-way bet" strategy. On the assumption that real estate
prices would rise indefinitely, these firms borrowed cash to buy mortgage
based loans. In a rising real
estate market, outsized profits could be obtained; in a falling real
estate market, however, capital is vaporized. By last week, losses for Fannie Mae,
Freddie Mac and Lehman exceeded their capital base. Merrill Lynch is in slightly better
shape, but with real estate prices projected to fall through 2009,
management elected to sell now rather than follow Lehman into bankruptcy.
Fannie Mae and
Freddie Mac are in the business of buying loans, but how did Lehman and
Merrill end up in similar circumstances.
Over the last decade, the core businesses of broker-dealers became
ever less profitable. Commission
income from stock trading is negligible and copy-catting of investments
products drove the margins of most offerings to zero. Many broker-dealers boosted the capital
allocated to proprietary trading, including, unfortunately, the mortgage
groups. Goldman Sachs and Morgan
Stanley are in similar circumstances, but, so far, have avoided the
losses that took out Bear Stearns, Lehman and Merrill. The big five is now the big two.
Impact on
our clients
Historically we
have never had much investment in broker dealers. In good times, all those firms' profits
are paid out in salaries; in bad times, it's just bad times. We own no Lehman Brothers stock. We have tiny positions in Merrill
Lynch, Goldman Sachs, Morgan Stanley.
We had tiny positions in Fannie Mae and Freddie Mac which we sold
at the open last Monday. We had a
small position in WaMu, a commercial bank, which we sold last week. We have a small position in AIG, which
we will hold for now.
Unfortunately,
quite a few other investors, especially leveraged investors such as hedge
funds, have taken major hits this year.
They are in the position of having to sell stocks not because they want to, but because they
have to. The worst pressure is on
financials. Even companies in good
shape like JP Morgan and Goldman Sachs look to be down 10% on the
open. However, companies like
Cisco and Microsoft, which have no financial exposure, will open down
3-4%. All the factors we talked
about in last week's commentary on market volatility will exacerbate the
initial down move. At the same
time stocks have gone from cheap to ridiculously cheap, so plenty of
people, ourselves included, are looking to buy.
Strategy
Our strategy
remains unchanged from last week: "We felt that the July 15th
sell-off marked the low for this particular bear market. Our analysis was tested earlier this
week by the demise of Fannie Mae and Freddie Mac, but at least as of this
morning, the mid-summer lows are holding. Stocks looked equally grim June
2002 through March 2003 at the tail end of the last bear market. Once investors finally got their
bearings, US stocks gained 34.6% over the following year, 41.7% over two
years, and 58.2% over three years.
There is no guarantee that we'll see similar returns over the next
three years, but historically those investors willing to hold stock
positions through the end of the bear market obtained the largest
returns. Our job at this stage of
the game is to keep clients invested to reap the rewards of
patience."
Yours sincerely,
David Edwards
President
The Heron Capital Management
client letter is published immediately following month end and when
market conditions require comment. The views expressed in this letter
represent HCMI opinion and strategy as of the date published and can
change at any time upon receipt of new information. Data quoted in this
letter are from sources deemed reliable, but no guarantee of such data is
implied.
|
