What's Next for the Financial Sector?

The selling climax, and apparent capitulation of the financial sector, which, like night follows day, will be accompanied by a massive counter-rally fueled by short covering, is a when, and not an if, event. Like-minded analysts will no doubt be in agreement with this characterization of the next phase that is most likely to occur, even though several issues seem likely to be in dispute:

What is the quality, magnitude, and duration of what may be a bear market rally in the sector?

Given the central role of capital intermediaries, what is the relevance for the rest of the market, especially the former leadership groups, such as materials, technology, healthcare, and energy? (Have they topped out? Are they in the incipient stages of a major correction or, are they also joining the group in a bear market move? How, and when will we know?)

What are the implications for global markets, especially those in Europe and Asia that are non-dollar denominated?

As students of the financial institution sector, we always attempt to estimate what the market is discounting in terms of earnings by using an imputed value methodology (ROE/Price/book), and using a base case scenario for the eocnomy, interest rates, credit spreads, Federal Reserve policy. We think returns on equity for the sector can normalize by 2009 from the low double-digits to the mid-teens, which is still well below the trend that has existed for the last five or even ten years (high teens) for the corporate and investment bankers, but that is more than adequately discounted by the decline since the spring/summer period.

Having been relatively bearish (early) at least since 2005, we believe that the magnitude of the collapse in market capitalization has taken the sector too far, too fast, and that the consolidation and capital rebuilding phase will probably last, at least through next year, with dividend cuts and all. The absolute decline from peak capitalization in mid-2007 is fast approaching $500 billion for the sector (as measured by the S&P) from its peak of $2 trillion-plus. One should view this loss as reflecting both reported and anticipated credit losses, as well as reduced prospective profits in numerous non-credit related, and fee businesses as a consequence of the contraction through 2008, which is a reasonable time frame for forecasting. The number that has been bandied about the most is two or three hundred billion (or more) in sub-prime, prime, auto, and corporate credit (only a fraction of which actually has been confessed to) losses.

At a very conservative (sector valuation) of two times book value, the market is effectively discounting on the order of $250 billion in additional losses (i.e. from the pre-collapse run rate at the credit cycle trough) already. (One thing to keep in mind is that the losses are not all going to be housed in U.S.-based institutions either.) That number leaves little room for improved credit thanks to loss mitigation, the beneficial impact of additional Fed easing (i.e. re-financings), “cure rates” on mortgages and auto loans, improved origination margins (from levels taken from the second half of 2007) across the new business, and the like. It’s hard to paint the picture for 2008 any uglier than the market is already doing by pricing the stocks the way the market is, unless of course, one has a much clearer crystal ball. Given the record of market exuberance as recently as last spring, one should be forgiven for being un-convinced that fear is taking over in the same manner that greed did in the spring with the broker dealers.

At that time, this sub-sector (Goldman Sachs (GS), Morgan Stanley (MS), Merrill Lynch (MER), Lehman Brothers (LEH), Bear Stearns (BSC) could hardly have been painting a rosier picture for themselves, and their prospects. For as far as you could see, they were trading at well over two times book value, and the discounting ROE’s (based on our imputed valuation methodology) were in the low to mid-twenties. By the time, the broker sub-sector selling climaxes within the next week at close to 125% of book (except for GS), they will be discounting 2009/2010 ROE’s at less than half peak levels (remember there will be far less leverage to goose ROEs for a few years at least)

Our second point suggests that the magnitude of the decline is close to matching that of the two most recent crises in percentage terms. And given what we believe is (at least temporarily) a floor for the stocks, the opportunity of missing some of the substantial near-term upside (powered by a massive short covering) is substantial, should investors start to perceive a less than worst case scenario through 2008. That is also betting on some “selling of the winners,” and the end of the divergence in performance between this sector and the leadership groups of 2006/2007. At a minimum, some sort of long/short arbitrage (financials/’07) seems like a lower risk trade

Third, the weight of U.S.-based financials continues to diminish on both an absolute and relative basis, a trend that will no doubt be a major corrective mechanism for excesses in both directions. (i.e. There is a little bit of the tail wagging the U.S. dog, here). Global financials have held up better, and the ability for cross-border mergers, with a new depreciated dollar makes trough valuations probably within winking distance