|
Update
regarding the European banking crisis
Our commentary
below was written Saturday, October 4th. On Sunday, October 5th,
French bank regulators moved to merge Fortis Bank (the Belgian equivalent
of Wachovia Bank) with BNP Paribas, while German bank regulators
organized a $68 billion rescue of Hypo Real Estate Holdings, a private
sector equivalent of Fannie Mae.
European stock markets opened down 5% on the news and closed down
7-9%, even as many European governments rushed to reassure depositors by
eliminating any insurance ceiling on deposit accounts (part of last
week's Economic Stabilization bill includes raising FDIC deposit limits
from $100,000 to $250,000.)
US markets opened
down 4%, sank as much as 9%, but rallied in the afternoon to close the
day down 3.8%. At one point 75
stocks were trading down for every 1 stock trading up - that could be a
record even compared to the 1987 stock market crash! At the close, 9 stocks were down for
every stock that advanced.
Reactions like this absolutely, positively make no sense other
than because individuals and institutions are liquidating assets at far
beyond fire sale prices either out of fear or because they're facing a
margin call.
We absolutely,
positively are not selling anything.
One additional
note: because of the passage of Friday's bill, the SEC has decided to
rescind the ban on short selling as of Wednesday, October 8th,
canceling the previous extension to October 18th. This is another bone-headed move by the
SEC, which has completely failed to do its job policing the markets
against manipulation over the last 8 years.
The Great
Margin Call of 2008 (from October 4th)
September was a
horrific month for stocks, with October hardly off to a good start. Not only have US and international
stocks sold off violently, but other asset classes including municipal
bonds, corporate bonds, and preferred stock, commodities, including oil
(down 37%) and gold (down 19%), and even the Euro (down 15%) and British pound (down 16%) were
dumped. Leveraged investors,
primarily hedge funds, are going out of business at the rate of
2-4/day. When those funds can't
sell what they want, they have to sell what they can. Individual investors are not only
liquidating their mutual funds, but even bank CD's. Should we join the melee, selling our
positions now in the hopes of buying them back later at a lower
price? Or should we hold what we
have on the expectation that the measures taken to stabilize the world's
banking systems will lift stock and bond prices over the next 3 months?
In September the
S&P 500 fell 9.0%, the NASDAQ 12.0%.
For the week of September 29th-October 3rd,
the S&P 500 fell 9.4%, the worst week since the 9/11 terror
attacks. The S&P 500 is down
23.9% year to date, down 30.3% from the year ago record and back to the
level last seen October 2004.
An obvious
question: could stocks reach the lows set in 2002, which is to say
another 27% lower from here? The
collapse of stocks in 2000-2002 was an issue of over-valuation. A quick measure of the riskiness of a stock
or index is the Price/Earnings (P/E) ratio. You divide the stocks' current price by
one year's worth of earnings. A
stock priced at $20 with earnings of $1.25 has a P/E of 16. If an analyst projects that the company
will earn $1.50 next year, then we a compute a forward P/E of 13.3. All other things being equal, the
company with the lower P/E is the less risk stock pick.
When the S&P
500 peaked in March 2000, its P/E ratio was 32 - high but not
extreme. While the Price side of
the equation declined by 50% over the next two years, the Earnings side
declined by 85%, lifting the ratio to a record 62 by March 2002. Over the last 25 years, the P/E on the
S&P 500 averaged 21, with a low of 10 set in July 1984 when the yield
on the US 10 year Treasury bond peaked at 13.8%. With ten year interest rates currently
at 3.6%, the current P/E ratio of 21 is more than reasonable.
The Fed Model ties
the two together. From 1996 until
2001, the actual value of the S&P
500 exceeded the
fair value, at one point by 110%.
At present, the S&P 500 is undervalued relative by at least
40%. The discrepancy could of
course widen. Earnings of the
Financial (banks) and Consumer Discretionary (housing, autos) sectors are
still falling in Q3 2008, but are projected to turn positive in Q4 2008.
|
Sector
|
Q3
08
Proj. Growth
|
Q4
08
Proj. Growth
|
2007
Rep. Growth
|
2008
Proj. Growth
|
2009
Proj. Growth
|
|
Energy
|
31.76%
|
33.21%
|
12.83%
|
28.70%
|
15.64%
|
|
Tech
|
11.86%
|
11.32%
|
18.83%
|
14.88%
|
14.77%
|
|
Healthcare
|
10.99%
|
14.47%
|
16.98%
|
13.42%
|
13.19%
|
|
Industrial
|
10.42%
|
13.79%
|
17.17%
|
14.22%
|
8.43%
|
|
Cons. Stap.
|
8.47%
|
9.30%
|
12.56%
|
10.36%
|
10.79%
|
|
Utilities
|
5.15%
|
6.25%
|
9.09%
|
5.85%
|
10.79%
|
|
Telecom
|
4.00%
|
1.22%
|
-2.94%
|
8.08%
|
10.79%
|
|
Materials
|
3.31%
|
8.91%
|
12.94%
|
5.57%
|
10.79%
|
|
Cons. Disc.
|
-2.89%
|
5.93%
|
8.43%
|
1.49%
|
10.79%
|
|
Financial
|
-12.88%
|
11.04%
|
5.34%
|
-5.21%
|
10.79%
|
|
S&P 500
|
6.54%
|
11.42%
|
12.78%
|
9.83%
|
10.79%
|
(from
Zacks)
As we don't know
the full impact of the credit crisis yet, earnings for the other sectors
may be too high, but even trimming 3% still leaves overall growth in the
8% range.
The Credit
Crisis
On August 31st,
we were reasonably confident that the crisis among banks and mortgage
providers was manageable. Five
days later, Fannie Mae and Freddie Mac were taken into receivership by
the US Government, setting off shock waves in the world's financial
systems which have yet to subside.
At present, banks are too risk averse to lend to each other, let
alone to companies and individuals.
Under normal circumstances, banks lend excess reserves to each
other for a three month term at about 0.75% over three month T-bills. Since mid-September, the spread on 3
month loans surged to 3.85% over T-bills.
The only good news is that the overnight loan rate, which peaked
at 4.875% over Fed Funds on
Thursday, slid
back to the more normal 0.375% following US Congressional passage of the
2008 Economic Stabilization Act on Friday. The commercial paper market is frozen,
which means that AAA rated corporations can't obtain routine short-term
cash. There's plenty of anecdotal
evidence that college students can't get student loans, auto-dealers
can't finance inventory or make car loans, farmers can't buy fertilizer
and seed.
After adding $150
billion in "sweeteners," Congress voted in favor of the
Economic Stabilization Act on Friday.
The Senate already approved its version on Wednesday, so with the President's
prompt signature, the Treasury moved forward to implement the strategy -
hiring up to 10 fixed income managers who would establish a mechanism for
valuing and buying mortgage backed securities from banks.
The chief
complaint of legislatures who voted against the bill was, "Why
should Wall Street get $700 billion, but not Mr. and Mrs.
America." In fact, individual
homeowners earlier this year were already beneficiaries of a $160 billion
tax rebate and a $400 billion "HOPE for Homeowners" loan
refinance program. Despite that
stimulus, home prices continue to fall, which reduces the value of
mortgage securities still held.
"Mark to market" accounting rules require the banks to
charge unrealized losses against equity - so far about $600 billion. Banks typically lend $10 for every $1
in equity, so the losses so far have reduced lending capacity by $6 trillion. The banks won't get par (the original
price they paid) for their distressed securities, more like 10-40 cents
on the dollar, but won't be exposed to further write downs if those
securities continue to decline in value.
If the program is fully implemented, the $700 billion Treasury
program become $7 trillion in bank lending capacity, more than offsetting
the capital destruction of the last year.
Will the
"Troubled Asset Relief Program" work?
We earlier
described the 2000-2002 bear market as an issue of stock
overvaluation. The current crisis
stems from lack of confidence in the credit system. It will take a minimum of 2-4 weeks to
get the TARP operational. Housing
prices are still falling at a 16% year over year rate, are back to the
levels of July 2004 and could fall further through 2009 (in recent
months, the rate of decline has slowed.)
However, the Treasury can afford to sit on these securities for
years, and could possible even make a profit when home prices start
rising again. We have no doubt
that without this program the banking system would be unable to function
normally, driving not only the US, but European and other economies into
an extended recession. We'll
continue to monitor interbank lending spreads, which we expect to start
dropping as early as next week.
US
Presidential Election
McCain led Obama
in national polls for a couple of weeks after the Republican convention,
but still trailed in the electoral count (selection of Governor Palin of
Alaska as his running mate generated enthusiasm among the otherwise
disaffected Republican base.) In
recent weeks, Obama took a commanding lead at the national level, which
we expect will carry him through the election in November. McCain did himself more harm than good
"suspending his campaign" to return to Washington in support of
the Economic Stabilization Act.
Obama appeared "more presidential" in his measured
comments on the crisis. In the few
interviews granted since Palin was nominated, she demonstrated as much
knowledge of world affairs as the average college freshman - that's not
good enough. The fact that the
situation in Iraq has clearly improved this year gathers no headlines and
garners no points for McCain, who supported the "surge" that
allowed Iraqis to regain control of their country.
We commented two
years ago that all Democrats had to do to win the 2008 election was to
retain all of Kerry's states from the 2004 election, plus one or two
more. McCain is not ahead in any
state which voted Democratic in 2004.
Obama, meanwhile is ahead in the formerly Republican states of
Ohio, Florida, Nevada, Virginia, North Carolina, New Mexico, and
Iowa. The margin in many cases is
still less than the margin of error, but any one of the larger states or
any two of the smaller states gives Obama enough electoral votes. Given that everything the Bush
administration has touched in the last 8 years has turned to lead, we would
expect the Democrats to be ahead by huge margins so there's still
enormous doubt that Obama can do the job.
Regardless of who
wins, the new president will have to start with a blank sheet of paper on
economic priorities. The
additional financial programs of the last year have increased the budget
deficit by 25% and the national debt by 10%, leaving little cash for
healthcare, alternative energy or the environment. Taxes for sure are going up.
Strategy
We're in a period of
market turbulence not seen since the weeks after the 9/11 attacks. The mood is as gloomy now as it was
then, although thankfully we don't have 3000 grieving families. Over the next 4 weeks, we'll see how
earnings of companies outside financials are faring. There are plenty of companies like
Intel, Microsoft, and PFE that have plenty of cash, are still generating
revenues more or less in line with expectations, and yet are trading at
the lowest valuations in 20 years.
It was encouraging to see Warren Buffet invest $5 billion in
Goldman Sachs, $3 billion in General Electric last week. With Wachovia and WaMu gone, there are
only a couple of smaller banks in eminent peril of takeover. Meanwhile, the stock prices of JP
Morgan, Citigroup, Bank of America, Wells Fargo, and US Bancorp are well
off the July 15th lows, and several are at or near 52 week
highs.
Before we step up
and actually buy stocks again, we need to wait at least a month to see
how the TARP is received and whether interbank lending stabilizes, what
happens when the prohibition on short selling financial stocks is lifted
October 17th, and who finally wins the US presidential
election. We may well look back at
this period a year from now as a marvelous buying opportunity, but
investors everywhere are waiting for someone else to take the first step.
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.
|
