Collapse of bank stocks drives US stock market to 12 year
lows
The S&P 500 financials sector, which includes banks, brokerages and
insurance firms, fell 18% in February on top of January's 26.3% decline,
for a total decline of 39.6% in the first 9 weeks of 2009. This
sector is down 80.2% from its all-time high in February 2007 and is at
the level last seen in December 1994. Within the sector, Citibank
is down 97%, Bank of America is down 93% and AIG is down 99.5% from
recent highs. However Morgan Stanley and Goldman Sachs, while well
off 2007 highs, are up YTD, so at least some banks are doing
better.
Last month, we asked the question, "Can the banks be
saved?" The answer so far seems to be yes, but
selectively. So far in 2009, about 19 smaller banks have been
declared insolvent and taken over by the FDIC. Shareholders are
wiped out, but for the most part the day-to-day operations of these banks
are unaffected while the FDIC merges the remaining assets of the bank
with another firm. Depositors and checking account customers are
unaffected, borrowers still owe their mortgage payments, checks and
credit card continue to work. 2800 banks disappeared in the
1982-1992 banking crisis, and most Americans don't even remember that
period. 10,000 banks went out of business between 1929 and
1932. In that period, deposit insurance did not exist, so every
bank failure entailed the wipe-out of all its depositors.
"Bank nationalization" was hotly debated over the last
month. The Obama administration has made clear that it will only
take ownership of banks as a last resort as we saw with Citigroup on
Friday. Paying a 10% dividend on the US Government's purchase of
preferred stock in Citigroup was not sustainable given its constrained
capital situation. The preferred shares are converted to
non-dividend paying , and Citigroup is required to find private investors
willing to match the government's investment dollar for dollar, leaving
the US owning 36%, new owners 36%, and current shareholders 28%.
Still, 28% of something might be more valuable that 100% of
nothing. Bank of America could be the next candidate for similar
treatment. PNC Financial, US Bancorp and Wells Fargo are also
potential candidates. As investors are afraid to own stocks that
might be diluted by government ownership, they're frantically selling all
banks. Given that quite a few smaller, regional banks avoided
investing in toxic mortgages, that selling is overdone.
AIG is 80% owned by the US government and has already received $150
billion in aid of various forms, but may need an additional $100 billion
to avoid the collapse that Lehman suffered last September, which placed
the world's financial system on its current downward spiral.
When does a recession become a depression?
The Great Depression lasted 10 years with 25% unemployment, 24% shrinkage
of GDP, consumer price deflation of 23% and an 86% decline in the value
of the S&P 500. The current recession is 15 months old with
unemployment at 7.6%, a decline in 4th quarter GDP of 6.2% and a 53%
decline in the value of the S&P 500.
Economic forecasts for the US are at this point wildly divergent.
The current recession could end as early as Q3 2009, or not until the end
of 2010. Unemployment could rise to 9% or even 11%. Some
analysts think that stock prices could fall another 15-20%, although even
using the most pessimistic assumptions, stock valuations are at the
lowest level since 1982.
The key issue is whether inflation, currently at 0.0%, becomes deflation
(i.e. negative.) In that environment, nobody will buy what will be
cheaper tomorrow. Given that retailers can only sell at massive
discounts, cars and homes aren't selling at all, and commodity prices are
down 45-70% from summer 2008, we're surprised inflation isn't sharply
negative already.
In the 1930's, the money supply crashed 25% as banks shuttered.
Without cash, consumers were simply unable to buy goods, hence the 23%
decline in prices. In the current environment, consumers are cut
off from credit (no more home equity loans or credit card offers).
The fear of unemployment and the loss of trillions of dollars in paper
value in home prices and investments accounts have caused consumers to
become much more cautious about spending. The US savings rate,
which was briefly negative in 2004 (consumers spent more than they
earned, borrowing the difference) is now sharply higher at 3% of incomes
and expected to go to 5-6%. The increased saving would shrink the
money supply, except that the US Treasury is aggressively pumping money
into the system by buying up securities from the banking system.
The cash deposited into banks to pay for the securities offsets the
shrinkage in the money supply. This may cause inflation in a couple
of years, but it's worth taking the risk to avoid deflation now.
The worst recession of the post war era was in 1980-82. Reacting to
high inflation rates caused by adjustment to higher energy prices after
the Iranian Revolution of 1979, the Federal Reserve shrank the money
supply and raised Fed Funds rates to 20%. The rate on home
mortgages peaked at around 23%. Unemployment peaked at 10.8%, inflation
at 13.5%, and economic growth shrank 7.8%. Subsequent recessions in
1990-91 and 2001-2 were both short and mild.
The Fear of Fear Itself
To quote from Franklin D. Roosevelt's inaugural address, "the only
thing we have to fear is fear itself-nameless, unreasoning, unjustified
terror which paralyzes needed efforts to convert retreat into
advance." The new Obama administration is moving aggressively
to shore up the banking system, to stimulate the economy with deficit
spending, and to reduce the rate of foreclosures by getting cash to those
home-owners most at risk. However, as fast as these programs are
rolled out, hundreds of commentators rush to the airwaves and blogosphere
to explain why they won't work. Furthermore, every day when average
Americans get off work, whether at their gym, their bar, at home, on
their cell-phone, the Dow "bug," which has mostly been negative
for months, is right in their face. No wonder Americans are scared
to death. Until that fear dissipates, spending is limited to
necessities and investing is out of the question.
Strategy
The stock market closed February 2.3% below the lows of November 20th
and is 6% below the lows of the 2000-2002 bear market. However, the
volatility is way down. In one week last October, the S&P 500
fell 14.9% over 5 days, then rallied back 11.6% on the following
day. Hedge funds lost about 1/3 of their assets last year, and are
trading with reduced leverage, so their ability to "gun" the
market is sharply reduced. Retail investors have unfortunately
taken up various leveraged and sector exchanged traded funds with a
vengeance. In particular, heavy trading in ETF's related to the
financial sector has caused that group to jump around 7-10%/day in recent
weeks.
Eventually the problems of the banking system will dissipate.
Despite the current recession, corporate profits of non-financials are
158% higher than at the low of the 2000-2002 recession, and 48% higher
than June 1997, the last time the S&P 500 was at this level.
Even if we assume some shrinkage in corporate profits through 2009, the
stock market remains very cheap and massively oversold. We don't
know what will turn investor psychology around or when. We do know
that when this bear market ends, the first few quarters deliver the
largest returns. So we're holding the stock positions that we have
and waiting.
As always, please don't hesitate to call with questions and concerns.
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.
