Restructurings and Bailouts

The news today about Bank of America (BAC) (bailout) and Citigroup (C) (restructuring) has both names indicated higher along with the broader market but this entire episode continues to fascinate. The short term implication is probably positive (said with not much conviction) but the longer term implication is...well...what exactly is it?

Regardless of what you thought about Fannie and Freddie they were vital cogs in the machine and now they are gone (not really gone but much different than they were). The biggest banks from two years ago have failed one way or another. The biggest investment banks have either failed or technically are no longer investment banks. This has forced the government to have a large role in fixing things--or more correctly trying to fix things.

If it is correct to say that the US financial system has collapsed (I will let others decide if that description is correct), we should perhaps count ourselves lucky that stocks have not dropped more. Obviously some folks are calling for a much larger decline still to come. I do not think there will be new lows that are meaningful but of course any opinion like that can be wrong. I still believe in a large bear market rally to come and a run down toward the lows after that (maybe the run up to 931 was the rally--smaller than I would have thought-- but I don't think so).

One other reason why I don't think we go dramatically lower than the lows already in is that the shock factor is now gone. Asset prices have plummeted, institutions have failed or been bailed out, foreclosures have gone way up as has unemployment. If the shock factor is gone then there likely would be less of an emotional response which in turn would mean the lows for equities are in even if we churn around the lows for a while to come.

Or not. What do you think?

Comments

[User 338732:]

Profit margins have topped and will revert back to mean, if not overshoot. P/E ratios will drop to below 10. Currently at about 15: You think it's going to 20? Adds up to 500-600 on the S&P given RATIONAL scenario. If another IRRATIONAL (e.g. 1974) scenario hits, figure on 300-400 on panic selling. Is anybody really making the argument that inflation will goose lending and take us back to increasing GNP? Specious.

Jan 16 12:36 PM

[jepittman:]

It seems to me that each panic attack since the Oct low (nov and so far in jan) has been on lower volume and lower volatility. This jives with the author's belief that the 'shock factor is gone'. IMO it will take another pretty big shoe dropping to reignite fear to the levels we saw in the fall. This is not to say the big shoe is not looming but so far it looks to me like a bottom is forming.

It is hard to predict the catalyst for a resumption of a bear market rally but it could be an announcement by the incoming administration that 'mark to market' is going to be suspended. If it appears that the worst of the bank's writeoffs are over, the banks may rally carrying the rest of the market with them. Wishful thinking for sure but not implausable.

Jan 16 04:15 PM

[k45:]

I suspect that most of the future bad news is already built into the market. Sure, things will be pushed around a lot by the speculators and momentum players, but the majority of the market participants already expect the worst in the economy.

Jan 17 08:52 AM

[OldLimey:]

Interesting to see these comments that the bad news is baked in. That could be true, but a couple of things strike me at a very superficial/non-techni... level.

1. If 12 months ago somebody had mapped out to Mr. Nusbaum and the commenters above where the market would be under the type of scenario we face today, I wonder whether they would have answered with figures as high as the November lows. I think I would have guessed lower.

2. Whilst we certainly had panic at various points last autumn, were we ever allowed to panic quite enough? We can debate endlessly whether or not there really has been a plunge protection team at work and whether or not the Fed has been an active buyer of equities, but what I think is undeniable is that initiatives and news announcements have been 'spun' for maximum market-boosting effect. None more so than the BoA and Citi announcements just ahead of options expiration the week before the inauguration. Has the market yet been allowed to find a bottom which the overwhelming majority of investors can believe in?

3. We might well be reacting less to each bit of bad news, but my sense of the market's reaction on Friday was that it is also getting 'bail-out fatigue'. Last year, every new bail-out was greeted as 'the big one' that would turn things around. Now there is a lot more sceptisism and I wonder whether this in fact means that rather than requiring a really big shoe to drop, all that the markets will need to get them to keel over is the metaphorical 'straw'.

It's anybody's guess, of course.

Jan 17 09:48 AM

[constantnormal:]

Roger, have you ever looked at the Japanese experience? It seems to me that we are more similar than different in our own ongoing real estate calamity.

In the case of Japan, they too lacked the will to let dead banks die, and kept dead/dying corporations of all stripes afloat through the gratuitous use of government debt.

And now they find themselves entering the 19th year of their ongoing bear market, with elevated unemployment all the while.

Try overlaying charts of the S&P 500 vs the Nikkei 225 from their respective peaks of Oct 2007 and Dec 1990. Then tell me how confident you are that we will not follow a similar path lower -- if we do, we're only about halfway down in depth, and only a few decades of time to endure. The Nikkei has dropped from over 38,000 in 1990 into the 8000's today. The S&P 500 has dropped from an October 2007 peak of 1552 to around 850 today -- looking at the twin peak of Y2K in the S&P, one could easily see a double-top retreating to somewhere in the 400's, if one subscribes to that sort of entrails-scrying.

So far, we have pumped more credit into C and BAC than they are worth, enough to create completely new banking institutions from whole cloth -- and yet these "banks" are still on the ropes, requiring an unending infusion of capital and credit.

But you think that the bottom is in. And you do this for a living?

Think the shock factor is gone? Just watch as negative earnings permeate the corporate landscape quarter after quarter, and unemployment rises in concert with declining corporate fortunes in a vicious cycle of bad financial numbers begetting more layoffs begetting worse financial numbers ... ever seen stagflation at work? This is the evil twin of stagflation, stag-deflation. Like it's sibling, it works not by dramatic moves driven out of fear and panic, but from a relentless, unending grinding away at investors and any lingering traces of bullish sentiment.

On a PE basis, we have a lot farther to fall until even our current earnings are fairly valued, and this in the context of an earnings landscape that is dropping like an anvil.

We have not even started actions to shut down the ARM scythe of economic destruction, and will likely see more millions of foreclosures over the next 3 years, as the next wave of ARM resets and soaring unemployment pushes more millions of homeowners into bankruptcy.

Our entire "plan" to date has been to pump credit into the lenders and let this fire burn itself out, devastating borrowers and the housing industry. We have now entered the stage where homeowners with conservative fixed-rate mortgages are finding themselves in jeopardy, as they are either laid off or forced to relocate for various reasons, and find that even with considerable amounts of home equity, the mortgage balance is more than their homes are worth. And home values continue to decline.

"we should perhaps count ourselves lucky that stocks have not dropped more" ... just wait. Large moves do not occur overnight. We will get bear market rallies, but in the face of unrelenting horrible earnings, historic highs in unemployment (I've read that if we calculated unemployment the same way that they did in the 30's, we would be at 17% right now), these bear market rallies will be either spirited and brief, or shallow and disappointing.

But keep that happy-talk coming. Bears need people to sell to. There's a significant rally of breadth and depth right around the corner. I can feel it in my bones.

Jan 17 10:03 AM

[vince v:]

I think when commercial real estate tanks that we will see another down leg. If not this, there seem to have been plenty of unforeseen circumstances that tipped the balance down before; and the next "last known problem" will do it again.

Jan 17 07:06 PM

[Roger Nusbaum:]

At 40,000 the Nikkei was at something like 50 times earnings. The nature of the cross-ownership of public companies and BOJ's decisions early on create an argument for each country's troubles having different circumstances. These facts don't have to matter of course but the differences outnumber the similarities.

Jan 17 07:36 PM

[Another View:]

If I went by these comments I would say the bottom is in. Isn't that a bottom - when all are negative?

Jan 19 02:42 PM