Will Financial Stocks Rally?

Wednesday, Goldman Sachs (GS) lowered its rating on Merrill Lynch (MER) (Dividend Growth Portfolio) based on a potential earnings write off related to the sub prime problem. GS also lowered its price objective for MER ($70) from $108 to $94 (our Sell Half Range is $93-99). More than a month ago I noted that we needed to be cautious of the financials until we had a better handle on the overall sub prime problem, in general, and its impact on each company, in particular. Since then the magnitude of the problem has been coming into focus as financial firms have acknowledged the extent of their exposure, their stocks have reflected this news and the Fed has committed to attempt to relieve any non sub prime liquidity difficulties--and that was the basis for the Dividend Growth Portfolio's purchase of MER.

My bottom line is that GS's report doesn't seem to provide any new insight. In fact as this is being written, it is being reported that Warren Buffet is negotiating to buy a stake in Bear Stearns (BSC), which appears to suggest that at least some of the smart money thinks most of the bad news in the financials is being discounted.

That said, GS may know more than is in their report; and the purchase of MER could have been too early. Indeed, we have stated repeatedly that our Buy Price Discipline, which is designed to select stocks that are at historical low absolute and relative valuations, almost by definition, will be too early and wrong on occasion since the only time stocks sell at low valuations is when either the Market or the individual company is having problems.

At the moment, MER remains in its Buy Range despite Wenesday's decline and I think that the GS downgrade is a case of shutting the barn door after the horse is out. But I have to emphasize that I could be wrong. If it is so, I remind you that our Stop Loss Discipline is in place and it is there to protect our portfolios' asset value during the inevitable tough times.

One final observation: if the rumor concerning Warren Buffett's interest in Bear Stearns is correct, it could mark the bottom for financials which could in turn mean that the performance gap we spoke of Wednesday between the industrial/material stocks and the financial stocks gets closed not by a fall in the industrial/material stocks but a rise in the financials--so much for the most likely historical resolution proposed by my favorite technicians. I highlighted the 'coulds' in the above statement because nothing has happened yet, so this is still speculation about how this bifurcated Market corrects itself; though clearly a price increase in the financial stocks would be a more optimal solution than a fall in the industrial/materials stocks.

Disclosure: Author has a long position in some of the above-mentioned securities.

Comments

[ratsharp:]

i'd be darned if buffet buys bear sterns... impossible..

2007 Oct 03 01:26 AM