Financials: How - And When - We Reached the Bottom

One never knows until long after the fact, of course, when stock prices reach the exact top or bottom of a given cycle. And, besides, trying to pick precise tops and bottoms always turns out to be a pointless, unprofitable game. So don’t even try.

Have I hedged myself sufficiently? Good. For, as it happens, I believe July 15, 2008 will turn out to be as good a date as any to mark the end of the long, painful bear market financial stocks have endured for the past 18 months. And more to the point, it marks the beginning of the greatest financial stock bull market in our lifetime, one that will be much broader than the bull market that began in 1990.

Caution! The observation above is offered to investors only. If you can’t stand the idea of seeing another, say, 20% on the downside, please stop reading at once and head back to CNBC.com. If you measure your investment horizon in weeks or months, please, for your own good and sanity, leave this site pronto.

But if you understand what drives stock prices, and have an investment time horizon of at least one year, feel free to keep reading.  And if you are a patient value investor, get out your highlighter and get ready to buy stocks.

I believe the current valuations of scores—even hundreds—of financial companies are wildly out of whack with the companies’ long-term earnings potential. The companies are extraordinarily undervalued, in my view. In the vast majority of cases, I can get comfortable with their potential future credit losses and (in the cases where they’re needed) the possibility of future, dilutive capital issuance.

With the gap between current market values and business values so wide, investors shouldn’t even worry too much whether July 15 was indeed rock bottom for the stocks. The margin for error today is so wide that any investor with at least a one-year horizon and a little analytical ability can pick huge winners.  We wouldn’t buy across the board, but the vast majority of the depressed financial stocks will survive, recover, and deliver high investment returns from these levels.

Why July 15 was Capitulation Day

Financial services investors had a lot to deal with last week. Do you recall? On Monday, they grappled with news that regulators had closed IndyMac the previous Friday. It was the third-largest bank failure ever. Also over the weekend came word that the Treasury Department and Fed had drawn up plans to stabilize Fannie Mae and Freddie Mac.

It was momentous-sounding news—but, if you think about it, not necessarily negative. IndyMac’s failure couldn’t have been a surprise, thanks to Sen. Schumer. And the prospect of a stabilized Fannie and Freddie should have been seen as a positive, both for the economy and other financials. Even so, investor angst rose and, on Monday, the XLF, an index of large-cap financial stocks, dropped by 5%, closing on its low.

Then came Tuesday, and already-nervous investors were hit with the following news items before the market opened:

1. GM suspends its dividend.
2. Retail sales for June come in lower than expected.
3. The dollar hits a record low against the euro.
4. June PPI comes in higher than expected.
5. Long lines ring IndyMac branches, as depositors of the failed bank seek access to their funds.
6. A popular bear, Meredith Whitney of Oppenheimer, lowers her rating on Wachovia to “underperform,” citing the company’s bleak prospects.
7. Bloomberg runs a story reporting that private equity investor TPG has already seen its spring investment in Washington Mutual cut by two-thirds.
8. CNBC interviews its new favorite investment guru, Bill Ackman, about his plan to “save” Fannie and Freddie.  Ackman, who admits he just shorted both companies, describes a plan that would wipe out common shareholders of both companies.

In all, it was pretty scary stuff to deal with in a highly fragile market.

Activity During July 15

So what happened next? The following events on the 15th stand out as being especially significant, in my view:

1. Financial stocks decline dramatically in the first 45 minutes of trading. It was an across-the-board collapse. Citigroup, which closed at $16.40 on Monday night, traded as low as $14.02, a decline of 15%. Wachovia, the subject of Whitney’s downgrade, was off by 20%.
2. The VIX hits 30.82 in the first 45 minutes. The VIX is of course everyone’s favorite measure of investor nervousness. Recent readings above 30 have signaled a peaking in the level of panic.
3. First Horizon’s stock rises at the open, despite all the bad news. First Horizon, a heavily shorted banking company, had moved up its earnings release to Tuesday from Thursday after seeing its stock decline 25% Monday over fears about its survivability. After the company released an earnings report that showed it was far from spinning out of control, its stock opened up 5%--despite the panic in the financial sector. The stock closed up 14% on the day.
4. Financial stocks stage a dramatic turnaround in the morning before closing lower on the day. For example, the XLF, after its initial 5% decline, rose 9% from the trough, but still closed down 3% on the day.
5. An incredible volume of shares trades.On July 15th, 469 million shares of the XLF traded, eclipsing its previous one-day volume record, set the prior Friday, by 150 million shares.  This record would fall two days later when 528 million shares traded.  July 15^th will be a day to remember!

Why July 15, 2008 Will Be Remembered As the Bottom

Beyond the highly volatile, dramatic trading patterns that happened on the 15th, conditions for a turn seem to be in place that will be familiar to anyone who’s lived through a market extreme before.

1. Long-term company valuations are extremely depressed. Before trading began on July 15, many financial services companies were trading at valuations wildly out of line with their long-term earnings prospects--simply because of excessive investor fear. The fear has come about from the very real credit problems that have developed over the last 18 months, and the unrealistic expectation that they will persist indefinitely into the future.
       With the banks stocks off by 50% in the last three months alone, investors seem to have been stunned into inaction, while bearish momentum investors have piled on their shorts. Rational analysis about companies’ long-term prospects has given way to the simplistic notion that chargeoffs must go higher, so stock prices must go lower. As a result, many financial stocks are significantly undervalued relative to their long-term earnings potential.
2. Bearish analysts have devised new methodologies to justify current or lower stock prices. Just as tech analysts rolled out new valuation methodologies to justify sky-high stock prices at the peak of the tech bubble in 1998 and 1999, bearish financial services analysts have developed new “methods” to “value” financial stocks to avoid recommending them now.
       They are nothing if not resourceful. One analyst, for example, estimates a bank’s entire future losses, deducts that number from tangible book value, then assumes the bank raises additional capital at current (highly dilutive) prices. Then he assumes the stock should trade at or below that estimate of pro forma, adjusted tangible book value. Potential book value growth from future earnings? A return to normal valuation? That counts for nothing.
       Clearly all the analyst wants to do is come up with as low a number as he can, whether it makes sense or not, in order to justify his bearish position.  This isn’t “conservative” analysis. It’s poor analysis.
3. New investment gurus are worshiped, while previous ones are said to have lost their touch. Remember back during the tech boom, when great investors such as Warren Buffett, George Vanderheiden, and Julian Robertson were suddenly seen as dinosaurs because they refused to participate in the mania? It was a new era, and those old guys “didn’t get it.” Today Bill Miller, Marty Whitman, Wally Weitz, and others are being criticized not just for their refusal to short the financials, but for actually owning them. People say that “this time it’s different,” and that these erstwhile investment legends suddenly don’t know what they are doing. I’ll bet on the legends.
       So who are the new media darlings?  One is Bill Ackman, a man with a mixed track record at best.  To show how crazy the current environment is, he shorts Fannie and Freddie on Thursday and Friday and then calls CNBC to tell them he has a plan to “save” the companies, which (what a coincidence!) involves a complete wipeout of common shareholders. And CNBC takes him seriously!  None of the financial journalists who interviewed him on July 15 questioned his true motivation.

Then there’s Meredith Whitney, who last year raced to become the most bearish bank analyst on Wall Street. She published her latest report last week and held a conference call with investors on July 15.  Her new angle: Stay away from bank stocks because future credit losses will be much higher than they think.  Why?  Well, Meredith discovered that the home-price futures that trade on the Chicago Merc are forecasting greater price declines than the banks expect. The futures market on which Whitney hangs her entire report has an open interest of all of 435 contracts, with a notional value of—are you ready?—$17 million. Since when do equity analysts rely on new, illiquid market pricing to do their forecasting?

4. Fears about dividend cuts and new, dilutive capital raised are excessive. Here’s a shocker: an investment bank specializing in the banking industry issues a report that predicts that . . . banks will have to raise a lot of new capital! KBW, the investment bank in question, is not famous for having an especially sturdy Chinese wall separating its research and corporate finance efforts. In any event, it says 180 banks need to raise $30 billion in equity, based on its own stressed-earningS scenario. Do you think the report was perhaps a little self-serving?
      In fact, I think second quarter earnings results are providing encouraging signs that the credit problems won’t turn out to be as great as widely feared, that not as much dilutive capital will need to be raised, and that fewer companies will have to cut their dividends.  For example, despite its strong recent bounce and better-than-expected second quarter earnings, Bank of America stock still yields 8.7%.
5. Second quarter earnings reports are so far encouraging. While commercial banks have mostly been the ones to report earnings so far, their reports have been encouraging with respect to credit quality.  I’m specifically referring to changes in delinquency rates, slowing inflow of new non-accruing loans, and the lack of meaningful increases in criticized assets. 
      Even the accounting for credit problems is improving, as companies have tightened up on the classification of loans 90 days past due but not on non-accrual. Banks seem quick to take writedowns on non-accrual loans and are aggressively building reserves.
      It is by no means clear sailing from here. Even so, the stocks are significantly undervalued under all but the harshest economic scenario. The evidence from second quarter earnings to date is that that scenario won’t come close to happening.

First Horizon: A Great Example of Undervaluation

To see the mismatch between a company’s valuation and the outlook for its underlying business, let’s look at one bank that’s been a favorite of the shorts: First Horizon (FHN). The company’s stock has been battered over worries regarding its mortgage subsidiary and its large home equity and residential construction loan portfolios.  Over the last year First Horizon has fallen from $35 to as low as $4.50 last Monday.

As I mentioned, the company last week moved up its earnings release because of the pounding the stock took on the 14th.  It reported a second quarter loss of 11 cents per share. Beneath the headline number, though, underlying trends in credit quality were encouraging, which made us increasingly comfortable with management’s worst-case loss estimates.

In a nutshell, here’s why buying First Horizon at the current $8.25 stock price looks like a great investment opportunity to us.

• Credit is stabilizing.
• Capital has already been raised and cash dividend eliminated.
• The stock trades at 66% of its tangible book value per share.
• The stock trades at 2 times pre-tax, pre-provision earnings.
• The stock trades at 4 times our estimate of “normalized” earnings per share.

I wish I could make this more complicated, but I can’t. The stock sells at an extreme valuation, even as signs emerge that its credit issues are manageable. And not only is capital sufficient, we believe it will prove to be excessive. Given all this, it’s not hard to see First Horizon’s stock price rising into the low 20s over the next 18 months. That’s a three-bagger on the upside without survival risk. I like that tradeoff. (And, yes, in case you’re wondering, we own First Horizon.)

First Horizon is just one of many, many financial services companies that I believe are ridiculously undervalued.  No, not all the performance indicators at these companies are headed in the right direction yet. But the signs of a turn are pretty clear. Investors know how expensive it can be to wait for an “all-clear” sign. I’m not waiting for an all-clear. Could the stocks’ prices correct after their strong advance? You bet! But for investors, the time to buy is now.

Comments

[buyitcheap]

author's call on Citi a few year's ago was spot on, it had a great run. Given the rebound in the last hour, we could be on a nice leg up in the financials. (long UYG).

[glassbox]

Tom, this is one of the best articles I've seen on this site and I do appreciate your blow by blow account around July 15 - although I must point out that you failed to mention SEC's move on the short sellers. Whether that had impact on the capitualation, nobody really knows but the results did speak for itself.

I'm long XLF and ABK - with at least 1 year horizon. XLF - am expecting US$25-30 by 1 year and as for ABK - I hope to see it go back to US$25, maybe not in a year but perhaps in the next 2 years... I'm sure if that happens, its worth the wait.

[IrrationalMarkets]

blowhard full of convictions on calling bottoms and tops.

[Pent updemand]

Don't count your money while you're still at the table.

[Tom Brown'sIntern]

Where is your macroeconomic analysis? What about the fact that the rate of defaulting debt obligations is increasing? J. Dimon says that PRIME loan losses could triple.

I agree that the Financials are undervalued by traditional metrics, however I don't expect to see a bottom until a few things occur (which we probably won't be able to ascertain until after the fact):

1) Defaulting debt returns to normalized levels

2) We have a ratings agencies overhaul, which will allow IB's to trade paper as freely as before they lost trust.

3) Oil falls & remains below $130

4) We have clear indication that unemployment has stopped increasing, CPI is 'contained'

5) We have 2 consecutive quarters without a large/mid sized bank encountering problems.

As 10+ years of inappropriate growth, which has obligated the govt. to back more paper than they are technically able, there must be a proportionate contraction based on the true valuations of not only the foundational collateral, but every derivative link in the chain above it (leverage). We have seen some of this, however this unwinding is very complicated, and the derivative debt spawned from this foundation is in the Trillions of dollars. The level of risk inherent to the market right now is higher than I think most people realize. I have heard quite a few 7 figure heavy hitters defend the JPM/BSC deal as having avoided catastrophe. If you have time, peek behind the curtain to see the moving parts of these statements...

Also, something to note is the velocity of money. Let's assume the above leads to a contractionary environment... As the VM slows (people & businesses unable or unwilling to spend for a variety of reasons, including difficulty in taking out loans), banks will lose out on a lot of transactional business. On the other side of the coin, they still have massive cashflow obligations that they support.

If inflation persists, and grows, big time pressure will be (is) on the fed to raise rates. Remember, they conducted emergency rate cuts in order to keep the banks from failing. When that wasn't enough, they just gave them money. The root of WHY, is defaulting debt - which is the crux of the matter, as articulated by Hank Paulson on CNBC the other day. If they have to raise rates, they kill banks.

[elcopone]

Good points DSB and good article Tom. I do however agree more with DSB. Any analysis of the financials without taking into account the macroeconomic picture is in my opinion, worthless. The underlying problems as to why the financials got into this mess have not been cured.

[morgan77]

Saw that the housing sector was the big winner last week and did a little more research on it. This article (www.greenfaucet.com/fa...) argues that housing may finally have reached a bottom. Check it out if you're interested in buying.

[CharlieStromeyer Jr]

Historically, during a major credit crunch the stock market bottoms before the credit markets start to recover which may be another reason to be bullish. (On Wednesday morning I went long IXG which is the iShares global financials ETF but I am ready to sell at any moment).

My question is how much credit derivatives such as credit default swaps (CDSs) are tied to commercial real estate (CRE) prices? I am asking because U.S. CRE prices are having a significant decline.

[CLH]

Very good article. Im in even though it may not be the final bottom.

[pshah]

Just like most folks on this site, I'm no expert at this. But let's consider people on opposite sides of this 'bottom vs. no bottom' debate:

No bottom: Jim Rogers, Soros, John Paulson, Phil Falcone, Jim Chanos
vs.
Bottom: Hank Paulson, our trusted govt., Bill Miller, author Tom Brown

First, we have a list of investors who have had a very long record of being right and succesful and who continue to bet against the financials and sell the rally (see WSJ today). Then we have the Pollyanas like Miller who's actually ranked in bottom 28% of fund managers by Morningstar for his 10yr performance and Tom Brown who's had a mixed record at best with his blunders like First Marblehead and CCRT.

Its a rout for the no-bottom team.

[Kinabalu]

Good article and good points by DSB. I do however agree more with Tom. DSB, by the time your 5 points have occurred we'll be past the bottom of the economy but we'll be LONG past the bottom of the market. Of course the level of risk is high right now, but the return potential is pretty high too. My vote is that the market is way ahead of the economy right now and the long term values are just too good to pass up.

[Tom Brown'sIntern]

Charlie, how much history can you rely on when the inputs to the market are vastly different than with previous credit related events?

To rattle off a few:

- We have never before had such a major crisis of confidence in the ratings agencies. Their job is to accurately asses the risk of loss, and assign a rating to that probability. They rated securities that were so complex that they didn't have any history on which to base their assumptions. The loss of credibility is crippling the market. Trust/Credibility is the glue that holds the world together. When someone don't know for sure whether to trust a propsective purchase, they rely on a 3rd party to recommend (a friend, an agency, references, etc). This is what the ratings agencies have done for decades, this is what makes the Ebay feedback system crucial to their business model. It is also why the world hasn't questioned the Dollar for 60 years. When trust is broken, the system will remain broken until trust is restored.

- The government hasn't had to back a major financial institution in crisis during ANY of our lifetimes, to my knowledge. This is egregious, possibly illegal, and in theory it dilutes the dollar. It takes credibility away from the fed and our currency - however if it was/is not done, we might be in a much worse situation today. Going forward, the fed will be limited in their ability to bail out institutions.

- Our economic strength is tied to our military strength insofar as .60c of every tax dollar goes towards the military. As the dollar weakens, and the tax base shrinks due to economic contraction, how are we going to maintain our global military campaigns. If we aren't the toughest kid on the block (aside from nukes), it becomes a lot harder to throw our weight around.

- The derivatives market has never been this big. A 70+ Trillion system of complex IOUs between financial institutions rests on a foundation of rapidly defaulting debt. During the credit crisis of the early 90's, it was around 9 Trillion. Think of an inverted pyramid. This is why BSC failure would have been catastrophic, as they held up around 8% of this system of IOUs (from what I recall).

- The savings rate in America is flat. This is going to get worse as prices inflate, and people (with all that 'money sloshing around on the sidelines') are going to hoard $ in anticipation of worse times ahead. When the velocity of money slows down, demand falls, companies go out of business, and people baton down the hatches. What will increase the velocity of money? Growth. How do you grow? There must be demand, prices must not choke people out of markets, and there *MUST* be liquidity in the system.

$120/bbl oil has already done damage. Companies have already laid people off in anticipation of hard times ahead, with two quarters of high energy prices putting a thumbscrew on margins.

Nothing goes up or down in a straight line. The fact that the Financials staged a rally 2 business days after the 3rd largest bank failure in US history tells me that people aren't educated as to the real risk in the system right now. It tells me that hopeless optimism persists, justified by "valuations,"... history, and a blind eye to the storm that the world is in right now.

Don't get me started on Europe, which suffers from a housing crisis very similar to ours.

Fix the defaults, fix the world. Save the cheerleader.

[fatcat]

DSB,I think you are right,there is not much correlation ,looking back,with what our financial fundamentals are now.Derivatives are the big question.Paulson has acknowledged that hedge funds will have to be rescued to prevent a slaughter..

[pshah]

Every quarter, with these 'better than expected' earnings, bulls crawl out of the bushes and start screaming victory. Give them a couple of weeks till reality sets in.

[robertredford]

Let's see. On July 15 Meredith of Opco fame issued a sell recommendation on WB @7.75 and within three days it almost doubled. Wow! How can I get a job at Openheimer?

[debtacid]

Ok, I will add this to the list...

July 15, 2008 Will Be Remembered As the Bottom
- Tom Brown.

"We will not have any more crashes in our time."
- John Maynard Keynes in 1927

"I cannot help but raise a dissenting voice to statements that we are living in a fool's paradise, and that prosperity in this country must necessarily diminish and recede in the near future."
- E. H. H. Simmons, President, New York Stock Exchange, January 12, 1928
"There will be no interruption of our permanent prosperity."
- Myron E. Forbes, President, Pierce Arrow Motor Car Co., January 12, 1928


"No Congress of the United States ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than that which appears at the present time. In the domestic field there is tranquility and contentment...and the highest record of years of prosperity. In the foreign field there is peace, the goodwill which comes from mutual understanding."
- Calvin Coolidge December 4, 1928

"There may be a recession in stock prices, but not anything in the nature of a crash."
- Irving Fisher, leading U.S. economist , New York Times, Sept. 5, 1929

"Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few months."
- Irving Fisher, Ph.D. in economics, Oct. 17, 1929
"This crash is not going to have much effect on business."
- Arthur Reynolds, Chairman of Continental Illinois Bank of Chicago, October 24, 1929

"There will be no repetition of the break of yesterday... I have no fear of another comparable decline."
- Arthur W. Loasby (President of the Equitable Trust Company), quoted in NYT, Friday, October 25, 1929

"We feel that fundamentally Wall Street is sound, and that for people who can afford to pay for them outright, good stocks are cheap at these prices."
- Goodbody and Company market-letter quoted in The New York Times, Friday, October 25, 1929


"This is the time to buy stocks. This is the time to recall the words of the late J. P. Morgan... that any man who is bearish on America will go broke. Within a few days there is likely to be a bear panic rather than a bull panic. Many of the low prices as a result of this hysterical selling are not likely to be reached again in many years."
- R. W. McNeel, market analyst, as quoted in the New York Herald Tribune, October 30, 1929
"Buying of sound, seasoned issues now will not be regretted"
- E. A. Pearce market letter quoted in the New York Herald Tribune, October 30, 1929

"Some pretty intelligent people are now buying stocks... Unless we are to have a panic -- which no one seriously believes, stocks have hit bottom."
- R. W. McNeal, financial analyst in October 1929


"The decline is in paper values, not in tangible goods and services...America is now in the eighth year of prosperity as commercially defined. The former great periods of prosperity in America averaged eleven years. On this basis we now have three more years to go before the tailspin."
- Stuart Chase (American economist and author), NY Herald Tribune, November 1, 1929
"Hysteria has now disappeared from Wall Street."
- The Times of London, November 2, 1929

"The Wall Street crash doesn't mean that there will be any general or serious business depression... For six years American business has been diverting a substantial part of its attention, its energies and its resources on the speculative game... Now that irrelevant, alien and hazardous adventure is over. Business has come home again, back to its job, providentially unscathed, sound in wind and limb, financially stronger than ever before."
- Business Week, November 2, 1929

"...despite its severity, we believe that the slump in stock prices will prove an intermediate movement and not the precursor of a business depression such as would entail prolonged further liquidation..."
- Harvard Economic Society (HES), November 2, 1929


"... a serious depression seems improbable; [we expect] recovery of business next spring, with further improvement in the fall."
- HES, November 10, 1929
"The end of the decline of the Stock Market will probably not be long, only a few more days at most."
- Irving Fisher, Professor of Economics at Yale University, November 14, 1929

"In most of the cities and towns of this country, this Wall Street panic will have no effect."
- Paul Block (President of the Block newspaper chain), editorial, November 15, 1929

"Financial storm definitely passed."
- Bernard Baruch, cablegram to Winston Churchill, November 15, 1929


"I see nothing in the present situation that is either menacing or warrants pessimism... I have every confidence that there will be a revival of activity in the spring, and that during this coming year the country will make steady progress."
- Andrew W. Mellon, U.S. Secretary of the Treasury December 31, 1929
"I am convinced that through these measures we have reestablished confidence."
- Herbert Hoover, December 1929

"[1930 will be] a splendid employment year."
- U.S. Dept. of Labor, New Year's Forecast, December 1929


"For the immediate future, at least, the outlook (stocks) is bright."
- Irving Fisher, Ph.D. in Economics, in early 1930

"...there are indications that the severest phase of the recession is over..."
- Harvard Economic Society (HES) Jan 18, 1930

"There is nothing in the situation to be disturbed about."
- Secretary of the Treasury Andrew Mellon, Feb 1930

"The spring of 1930 marks the end of a period of grave concern...American business is steadily coming back to a normal level of prosperity."
- Julius Barnes, head of Hoover's National Business Survey Conference, Mar 16, 1930
"... the outlook continues favorable..."
- HES Mar 29, 1930


"... the outlook is favorable..."
- HES Apr 19, 1930

"While the crash only took place six months ago, I am convinced we have now passed through the worst -- and with continued unity of effort we shall rapidly recover. There has been no significant bank or industrial failure. That danger, too, is safely behind us."
- Herbert Hoover, President of the United States, May 1, 1930
"...by May or June the spring recovery forecast in our letters of last December and November should clearly be apparent..."
- HES May 17, 1930

"Gentleman, you have come sixty days too late. The depression is over."
- Herbert Hoover, responding to a delegation requesting a public works program to help speed the recovery, June 1930


"... irregular and conflicting movements of business should soon give way to a sustained recovery..."
- HES June 28, 1930

"... the present depression has about spent its force..."
- HES, Aug 30, 1930

"We are now near the end of the declining phase of the depression."
- HES Nov 15, 1930

"Stabilization at [present] levels is clearly possible."
- HES Oct 31, 1931

"All safe deposit boxes in banks or financial institutions have been sealed... and may only be opened in the presence of an agent of the I.R.S."
- President F.D. Roosevelt, 1933

[Pent updemand]

Under what sort of accounting do we spend 60% of the government budget on the military?

As for the article, I would point out there was a similarly sized rally in financials from August to October last year, which has of course turned out to be a sucker's rally.

I think the scenario an investor needs to think very hard about is a situation where businesses start cutting jobs in a bigger way. What happens if official unemployment rises from these historically low levels? Then the other shoe would drop on the HELOC and credit card areas. Not a prediction; but in that scenario even the healthier banks will suffer badly.

[debtacid]

Also, does anyone notice a little cognitive dissonance here?

"trying to pick precise tops and bottoms always turns out to be a pointless, unprofitable game. So don’t even try."

"July 15, 2008 Will Be Remembered As the Bottom"

[Tom Brown'sIntern]

Sorry, I was off on the 60c. It is 42c. Maybe it was higher when I heard the statistic, my apologies.

Either way, this means that if you are in the highest tax bracket, let's say 45% of your income goes to taxes. That means that for the first 5.4 months of the year, 100% of your labor goes to the government. Of that 5.4 months, 2.26 months are spent on the military. So, 2.26 months out of the year, 100% of your work goes towards military spending and military debt obligations. For high wage earners, every hour of every day you work until the end of March goes towards war. HOOAH!

www.nationalpriorities...

en.wikipedia.org/wiki/...

www.truthandpolitics.o...

www.salem-news.com/art...

[Tom Brown'sIntern]

edit: until the end of the first week in March. I'm trying to work in between writing, and I'm rushing. ;-P

[debtacid]

Tom, I suppose this is just more proof that we already hit bottom?

"Wachovia Posts $8.66 Billion Loss, Slashes Dividend, Will Sell Assets"

[irondoor91]

Debtacid:
Let me add one more up-to-date quote to your wonderful list.

"This is far and away the strongest golbal economy I've seen in my business lifetime".


-Our esteemed Treasury Secretary Paulson, Fortune Magazine, July 12, 2007

(This couldn't have been much closer to the top and he neglected to mention the mountain of unservicable debt the "global economy" had been built on over the past decade)

[CharlieStromeyer Jr]

You make some good points, DSB. I myself don't trust the ratings agencies which is why I try to follow credit default swap spreads as a sign of potential trouble.

Also, according to the Bank for International Settlements (BIS), at the end of 2007 just in the OTC derivatives markets there was $596 trillion in outstanding contracts which was 8x the total value of all exchange traded financial contracts.

Until Tom Brown can convincingly explain why there won't be more blowups with derivatives then we should be skeptical that a bottom for the financials has finally occurred.

[Tom Brown'sIntern]

Tom, are you around to defend your thesis?

[urbansurvival]

Wonderful pipedream! Here's the reality: Housing loans over long periods have been 2.5-2.8 times household incomes. They have recently been as high as 4.5 times. As they revert to the norm (and may even overshoot on the downside) we'll be in what you'd call a Depression. Sadly, this is like calling the bottom in the summer of '29, I expect. Time will tell, but 7,500 on the Dow by Christmas seems a decent bet, although almost certainly before 2010.

[tk6910]

Tom Brown is a hedge fund manager who invests primarily in financial sector. That makes him a biased salesman, not an analyst. Shame on Tom Brown for hiding his true motive.

[buyitcheap]

consider too that we could just be in the midst of a major rotation out of oils, commodities, and into the beaten down sectors, financials among them. That doesn't mean an uptrend is permanent, but the increasing volumes would likely drive prices higher.

[Tom Brown'sIntern]

Buyitcheap, agreed. Financials have the potential to apply "claw of death" to anyone betting against them, until the next round of bad news.

Go to ibankcoin.com for some reality. Do not let children near the computer.

[themortgagedude]

He's wrong. Just dead wrong. The poster who posted about housing reverting back to 2.5 times income is spot on. We're not there yet and until we are problems will not stop.

[autboy]

LOL! debtacid: 1929-30 sure was quotable.

But DSB has touched the central nerve: how much betrayal of essential trust can a market endure and still hope to prosper. I am often struck by the conservative obsession with getting the government off the backs of businesses so they can create value, jobs, and provide more opportunities for wealth etc,. But seems to me that lays a responsibility on businesses - in this case the financial sector - not to operate so recklessly that government intervention is the only way to prevent collapse. How can anyone observing this situation from the outside rush back in to invest in companies that have behaved so irresponsibly?

[Back & Fill]

robertredford - Meridith has been spot on during this entire banking sector collapse. Also, 3 days does not make an investment. Wait until the fed gets done propping up the bank shares so they can finance themselves. I would call that a perfect short on the BKX.

[shure46]

we are reaping the results of counterfeiting 2 trillion dollars ...it's gonna take a while to absorb all that paper ....and of course the problem now is that we better not print any more ......so we have a few years of actually having to earn money instead of printing it ....which of course brings us to the next problem .....we don't earn money !!!!!!! China and Saudi Arabia earn money ....we print ......we cannot print forever ....soon the ink will cost more than a hundred dollar bill is worth .......just as a family cannot live indefinately on credit , neither can a nation .......and just as a family has to eventually hock the house ......so will this nation .....and real estate is the last thing to go before bankruptcy ......and if it were not for our military power , we would be up the creek right now big time ......unfortunately , the only solution we have now is to conquer the world .......in a global economy you must export more than you import .....and the only thing we export en masse is dollar bills .......oh , and I think a few american flags which are probably made in China .........of course there is one last ace in the hole for America .......the pope will have to loan us some money !!!!!!!! What , you think the pope visited the white house to talk religion ??????? George was hittin' 'im up for some dough !!!!!!! We certainly can't go on another printing spree , that's for sure ........

[winslow]

The entire financial fiasco lies with the Bush ideology. No other politician would have made these major miscalculations The last seven years have been a disaster in virtually every area of American life (except for the many corrupt CEO's)

[pooramerican]

Those who earn money, have trillions of dollars in their reserves. once they all move to a 'basked of currency' and their citizens reach 'consumer grade' we will no longer be necessary to fuel the global consumption.
I think we are due for a bounce technically, financials are beaten down and it is quarter time so we will see another 2-3 months rally of sorts. There is one glimpse of good news: investment banks are not borrowing as much in the last month or so. I suppose they made enough money buying oil futures and then raising price targets, good for them.
I want to buy potash companies but a little nervous, also want to buy some bulk shipping companies. certainly don't think financials are a bargain. I would go to tech though I think tech has been getting sold for such a long time and I think it is a sector that has a chance of survival especially tech services type not the hardware types.

[Pent updemand]

Oh, I knew it must be Bush's fault. What are you people with Bush Derangement Syndrome going to do next January? You'll have to start blaming everything on garden gnomes or water sprites I suppose.

You can lay all this at the feet of progressives, winslow. I mean the original progressives back at the turn of the 20th century who gave us the Federal Reserve system and the income tax. They set in motion the economic forces that are coming to bear on us today.

[User 68127]

Bitter, bitter, bitter, bitter, bitter! I suppose Tom Brown considers himself one of the "fallen legends" who is about to be vindicated?

[zenzender]

No Bottom. this is a forever Depression. For our lifetimes anyway.
The Globalists have no back up plan. Just cheap labor and use oil to ship it where it goes.

[JKC1967]

Is it possible to see merit in both Tom's case and DSB's? I think so. There is no diubt by traditional metrics banks are extremely undervalued, but it is impossible to leave out the general macroeconomic environment. If the Gov't end-up taking over/guaranteeing FNM and FRE, if housing continues to drop for for the next couple years, if the general process of deleveraging and defaults extends more broadly into other types of debt like auto and credit card loans, if the FED has to raise interest rates due to inflation....doesn't mean all of these things will happen, but any analysis of banking securities that does not take these risks into account seems flawed. Would love to hear Tom respond to DSB at some point....

[shure46]

I seem to have read somewhere that someone in Dubai is buying a large stake into GE .....and I am sure we will see much more foriegn ownership of our companies ......according to my ealier post , when your credit runs out , the last thing is hock your house ......and that is where we are now ....we can't really print any more money , we have flooded the world with printed money the last 8 years , and we do not earn more than we spend as a nation .......soooooo it's time to start sellin' the house and furniture .........and after that ??????? I guess we will have to sell our kids into slavery or something .....I know we are in deep sht when the credit dries up , and we have sold off all our assets .....oh well , we can enjoy ourselves watching our TVs ( made in china of course )

[Tom Brown'sIntern]

That's right, just keep watching your TV's people. America must have its next top model.

[ChannonH]

PLEASE: I beg of you, if you want to tie housing to income, do it in monthly terms, like home buyers do. Long term (equilibrium) housing prices are a function of income, tax treatment of mortgage costs (interest, PMI) and mortgage rates. A $250,000 house costs a dramatically different price when mortgage rates are 12% than when they are 6%. A $1MM house becomes significantly more expensive when Congress caps the tax-deductibility of mortgage interest.

To view it otherwise is a foolish "analyst mistake" repeated over and over by our innumerate journalists.

[DanSchmeidler]

This is a very misleading article. But I have to give it up for Tom Brown's brilliant timing. The article bases its assumptions on strictly stock meachnics and how stocks respond in extreme situations. We are in a very sad situation with equities, and our overall economic condition, especially in the financial sector. The equities within the financial sector got a big jolt that pushed them all higher. The question now is how well can they sustain their current levels. A lot of that is dependent on their abiliity for capital expansion. Unfortunately for them it is a diffucult road up from here on. Maybe a few more upward jolts the next few days, as investors interpret more bad news from the sector as the bottom of all bottoms and then drive their stock price higher. But, unlike investors in the last 7 trading days or so, those investors are going to be far and few in between. This will occur as the realities of the credit market will kick in. The effect of deleveraging inflated balance sheets will contract and constrict and choke anything that deals with the trading of financial instruments and severly punish everything that sits on a balance sheet that has anything remotely to do with leveraged derivatives and other financial instruments. In other words all the financial stocks are going to head lower. But that is not to say that clever, in fact, brilliant, (and deservingly so, well paid) fund managers such as Tom Brown are not going to have a field day obliterating the shorts and reaping the last bit of profits possible before the final curtain is drawn on them.

[Zeninvestor]

I agree. The bottom has been reached. With fits and starts we move upward from here in the financials.

[iThinkBig]

DSB has convincing arguments. None of us have lived through such unknowns, we have recently beaten a couple of Great Depression records. Keep in mind, historically financial tsunami's land 2-3 years after market crashes.

The comment from Shure which is a tad emotional but some nervousness is in order I suppose. Yes, foreigners are going to buy large patches of our infrastructure and the American average wage will be similar to other parts of the globe. Think Eastern Europe perhaps.

That part is not really scary, it simply sucks for 97% of the population which will no doubt figure this out and in the not so distant future. What is scary is that military and other national security secrets will go overseas. What happened in the mid nineties when the Administration permitted China to obtain missle technology for 'peaceful purposes'. Guess what? We now have 23 ICBM's from China aimed at the United States. Pakistan (our Al Queda buddies from the ISM) exported the know-how to nations like Iran. Yes, you get the picture. Best thing America can do now is go energy independent, accept the painful lumps and assure the world we will continue to service our debts and slowly repay them. To do that means the fact that inflation will be here to stay for a good long time and the over-all business environment will stink for many years.

[iThinkBig]

That's a good point Your_Avid_Investor.

[drmalaka]

This article is well thought out but just plain wrong.

Where are bank earnings? How much money are the Investment Banks going to make on M&A, securitization and the like in the next few years? It's hard to come near past earnings when you used to have ten revenue streams and you just lost your best three. Add that to dilution and the EPS will not approach past numbers for years and years.

Who is Tom to decide he is comfortable with write downs? Please. Three months ago when the last rally started (oh, during earnings season, or is that lying season) we were told that we were near the end of write downs. Believing anything the banks say or do is sheer insanity. These are comfirmed liars and crooks, and you take their word.

Sorry, but Whitney and Ackerman are much more reliable sources than any joker who pushes these banks. I think I will stick with believing those who have been right in this crisis, not the morons who keep telling me there is a bottom and no more write downs.

Estimates for losses are between $1 and $2 trillion now, are we even near that. Of course not. And that does not include normal loans, credit cards, commercial loans.

We will have write downs for years to come. The banks don't even know what is on their books. Their Teir III assets keep growing. Look for most of those assets to be written down eventually, quarter by quarter.

Bottom. Yeah right, bottom of the barrel maybe.

[User 228118]

Hey Tom,
Great article and overall.. you are on the money.. I agree.

[Kinabalu]

debtacid

I loved your list of positive economic comments from 1929 & 1930. But does everyone realize that almost 90% of the comments on this page are negative on the economy's direction. Now, that, if it extends to investors as a whole, has to have had an impact on the stock market right now.

[RAW thoughts]

From what I read above, principally the comments are of the opinion that we should wait until all the financials go to zero and that will be the time to get back in. That is akin to getting back into real estate after the asteroid has hit the earth. To me, there is more upside potential then downside risk given that there is still so much money looking for a home.

[alajac]

DSB is saying exactly what I would say if I knew as much as s/he does.

I am reminded of another Depression-era quote: "We thought it was over and it was really just beginning".

"God willing and the creek don't rise"

Well, it seems like the creek might be rising.

[Swiss_Buffett]

I believe 07/15 may indeed have been a bottom for the banks, but going out and buying with both hands is very risky still, if not foolhardy. 07/15 may not be THE bottom yet for banks. If there is prolonged economic downturn and recession because of the weak american consumer, it is inevitable that more - a lot more - writedowns await us in the future.

How much has been written down so far and how much is being discounted in the current depressed stock prices of banks? Well, a good chunk for sure. But today we only know so much. Even the best informed and well-intentioned insider may not know the full extent of mess that is still waiting for us out there.

On the other hand there will always be commercial banks around and in business in the US and elsewhere, of course. So it is a no-brainer to make a case for buying them - now or later.

Even assuming Tom is right in calling a bottom here, picking First Horizon as an investment candidate I find rather disturbing. There are certainly better alternatives available, like JPM, BAC and WFC. Sure these are rather dull ideas, but you can be certain that these will survive. A racy pick like First Horizon may very well get you in trouble still. I'd rather play it as safe as possible right now, and that means the biggest are the most likely to come through.

[CharlieStromeyer Jr]

User 225887 or anyone else, do you agree with some analyst whose name I don't remember who said that in terms of business recovering that first the trust banks will recover then the commercial banks and then last the investment banks?

[User 112599]

One of the principal problems that lead to the financial crisis was, I believe, the lack of transparency. Will the financial institutions volunteer useful-to-investor transparency? ? ?
Just as with Clean Air, Acid Rain, Redlining, Civil Rights and all the way to Slavery - Laws, regulation, public insight and scrutiny is essential for a stable society for all of us.

[Tim Plaehn]

The actual number of bank failures appears to be low, what is it, 5 so far this year? Most of the banks I am watching are still profitable at reduced levels and PE's are 4-6 on the reduced profits. Banks will be cleaning up their bad real estate loans for a few (2-4) quarters then profits will take off.

Banks have a nasty cyclical habit of piling on to a single idea until it collapses beneath them. In my memory this is a 15 to 20 year cycle, so we have a while before the memory of bad times for banks becomes fuzzy and they start acting stupid again.

For all of those that think this is the end of the financial system as we know it, what are you planning to do for money? Or all of you just long SKF and find yourselves 40% poorer than this time last week?

[Blaze]

DSB knows what he speaks about. Wachovia strikes out but they are allowed to trot the bases? It's short covering coupled with some momentum buyers. When the foreclosures come to an end, banks will be a buy.

[jlounsbury59]

Tom Brown - - -

Great article! Whether you are right or wrong you have created one of the most energetic discussion forums ever on Seeking Alpha.

[richrdinbellingham]

The author is leading the lemings of the cliff of financial disaster; I hope the information information in the linked article serves as "cliff notes" preserving the wealth of all who take the time to read it.

[valueinvestor123]

If Tom was such an expert in financials I would have expected him to have some great shorts on within the last year and a half, but instead all he had was many terrible long calls.

[beenaround]

Can't claim any expertise. Just an observation: each side of the debate cites only facts that support their particular argument and ignores offsetting information. I'm sure someone could pull together a list of spectacularly wrong bearish quotes. I also wonder if you can really draw parallels between an economy based primarily on manufacturing vs todays service/technology (intellectual) economy. I would venture to say that we are a wealthier nation now than in 1928.

I guess given the difficulty in figuring this all out, it makes sense that people take one side or the other and vigorously defend it. What I've learned from reading SA so far is that I'm either going to be very rich or live in a post apocalyptic world buying what few goods are available with hoarded gold. Can't wait to see how it turns out. Any moderates out there?

[oldtrdr]

Keeping it "short"...no pun intended...*VBG*...IF July 15th was "the" bottom, but there "may" be another 20% move down...WTF would one be buying now?

old trader

[NutritionFacts]

I heard there are about 100 other banks on the verge of going the same way as IndyMac et al. Can't remember where though.
Frankly it's ridiculous to think you can pin the tail on the donkey like this. Any serious trader/investor would know that. More than ridiculous; dangerous.

[LarryH]

The bottom has been reached, but be prepared for 20% to the downside? There is no way I can take you seriously.

[Swiss_Buffett]

Charlie Stromeyer Jr, you asked: Do you agree with some analyst whose name I don't remember who said that in terms of business recovering that first the trust banks will recover then the commercial banks and then last the investment banks?

I would agree trust banks recovering first appears very likely. I doubt they are at risk at all. Sure their base for earning their fees will get smaller, but essentially they do not take own risks, only handle other parties investments/portfolio. I think State Street Boston is a good example of such a bank.

If commercial banks will recover more quickly than a Merrill or Lehman? I would not want to wager a bet on either side. I'd say it's very much a case by case affair. Certainly Merrill and others like Bears (gone) and Lehman (almost), Drexel (gone), Salomon (gone), Kidder (gone), Barings (gone) have the rare talent to blow themselves up every couple of years with one new financial trick/fad or another. The only one smarter than the rest appears to be Goldman, but the final verdict is not out yet on GS. As a group the investment bankers appear to have virtually no risk management in place and are a greedy bunch altogether without much interest other than enriching themselves as quickly as possible. This works to their benefit as long as the particular fad in question works well (usually some 5 years), then when it's reckoning time they will go like: OK, tough luck. We didn't see that coming etc etc blah blah.... For the bigger ones (MER, LEH) they can fall back on the Fed or some other friendly Wall Street arrangement (Chase buying JP Morgan and now Bears, Citi swallowing Salomon). The others are gone, with a more or less golden parachute. Rinse and repeat.

All in all I'd say commercial banks operate more conservatively than the investment banks do. BUT their "conservativism&q... can be very reckless too, as can be seen now with Wachovia and UBS, among others.

What I find interesting is that even community banks and small regional banks and S&L's have subscribed to this lastest round of real estate bust. The principle of "knowing your customer" has been neglected wholeheartedly almost universally at all institutions small or large. Greed, once again, got the better of bank managements all over U.S. but not only in the U.S. I live in Switzerland and are the proud producers of one of the ugliest cases, UBS...

[CharlieStromeyer Jr]

Thanks for your answer, Swiss_Buffett, which I agree with.

Disclosure: One of the board members of a company that I advise is a manager at State Street in Boston.

[JimmyLathrop]

On July 22, 2008, UYG closed at 22.60.

On August 19, 2008, it closed at 19.23.

With zero transaction or commission costs, that's a decline of 14.91 percent.

Hey, maybe tomorrow will be a better day. Then again, maybe it won't.