The relative weakness of the financial sector portends a difficult road for the rest of the market in the second half of 2007, given the reduction in liquidity likely to ensue and the risk-aversion that is mounting.
Out of the five top US banks, only JP Morgan Chase (JPM) was able to eke out a positive return in the first half, with Wells Fargo (WFC), Bank of America (BAC), Wachovia (WB), and Citigroup (C) all substantially under water through the end of the second quarter.
We have repeated for some time that little extra money would be made [relative to cash alternatives] in the financial institution sector [which includes life and property/casualty insurance, REITs, banks, and consumer finance, GSEs]. The banking sectors’ relative performance has been one of the worst among financial institutions this year, so we think the wave of bank stock selling is likely to climax and then shift to the insurance sector in front of second quarter earnings.
Better opportunities for initiating short positions [two year horizon] now seem likely to be found in the property/casualty and life insurance sectors, as well as the asset management group. Philadelphia Consolidated Holding Corp. (PHLY), BlackRock Inc. (BLK), and Conseco Inc. (CNO) are our three top choices [W.R. Berkley Corp. (BER), Safeco Corp. (SAF), and Franklin Resources Inc. (BEN) as well.]
The stocks remain quite vulnerable due to the potential for material degradation in the prospective ROEs and the risk of valuation compression through 2008. There exists an insatiable appetite for p/c insurance stocks since they are, in fact, used as proxies for bonds, though it won’t take much of an earnings miss for the bullishness to evaporate.
The complacency surrounding the property/casualty insurance industry’s ability to sustain the current high teens ROEs seems naive, given the notorious cyclicality of the business, inflationary pressures mounting, and generally weaker economic condition in the US.
Additionally, [you heard it here first] the toxicity of the balance sheets of both life and p/c insurers, which has yet to be examined, will soon start to matter to investors. The industry balance sheet was bludgeoned in the Eighties and early nineties from holding junk bonds, though such concerns seem far removed from consciousness. It’s a “when”, not “if” issue, when the market starts to recognize the potential implications for this industry of toxic waste assets.
For longs, we suggest taking a look at some less obvious places; like the Government-Sponsored Enterprise [GSEs]. Freddie Mac (FRE ) and Fannie Mae (FNM) are well capitalized companies with stock prices that have done little over the last three years. In a more traditional conundrum, the stocks get punished when the companies reduce leverage and risk, while the Goldmans of the world get kudos for producing ROEs north of 30% by leveraging and risk taking.
Goldman Sachs' (GS) balance sheet is now comparable [in asset size] to that of the GSE’s, which have not expanded their balance sheet materially since the early part of the decade. [For comparison purposes asset growth for GS in the quarter ending in February exceeded 35% annualized.] As for Freddie Mac and Fannie Mae, the worst is likely behind them, and a period of value building seems to be gathering steam with prospective growth in book value [and stock appreciation] on the order of 12% to 15% annually for the next five years. That assumes a potential modest revaluation of the price/book in a period of rising long-term rates, widening spreads and a general flight to quality.