Buying the Oversold Financial Sector

Regular readers know that I have been bearish on both the economy and stocks for quite some time. While I certainly enjoyed the ride, I could not understand why stocks were rallying so strongly during the first half of 2007. Although the sell-off that began in mid-July did not surprise me, I was perplexed by the full and rapid recovery that immediately followed. Unfortunately, as we all know, those gains did not last very long. The S&P currently stands about 12% below its October peak.

It was obvious that economic conditions were deteriorating. There was much discussion about the housing bubble and the subprime mortgage crisis. Every rational investor had to be worried about the potential ramifications of these problems and the real possibility that they would spread to other sectors of our economy. Yet I found it incomprehensible how the eternal optimists kept downplaying these concerns. I don’t know how many times I was told that subprime mortgages represent just a tiny fraction of all mortgages, or that housing prices would never fall on a nationwide basis.

One prominent and perennial bull, who once chided the media for giving bears too much air time, recently argued there is “so little evidence of serious trouble” in the economy. Admittedly, this remark came before the 0.6% fourth-quarter Advance GDP figure was released, and before the Department of Labor said initial jobless claims jumped to 375,000, pushing up the four-week average by more than 10,000 to 325,750. Yet there has long been more than a little evidence that the economy was headed for trouble.

As for the argument that subprime mortgage problems would be contained, almost all financial institutions have already announced massive writedowns. This is no surprise. What is surprising, however, is a recent release from pharmaceuticals giant Bristol-Myers Squibb (BMY). Bristol said it took a $275 million impairment charge in the fourth quarter due to soured investments in auction rate securities (i.e., collateralized debt obligations backed by mortgages and credit card loans). Furthermore, Bristol no longer considers these investments liquid and has reclassified them from current to non-current assets. I suspect Bristol won’t be the only major non-financial company revealing these kinds of writedowns.

There is much debate about whether or not a recession is coming. In my view, it has already arrived. But whether or not it’s an “official” recession is largely irrelevant. The Federal Reserve is obviously so alarmed it has slashed interest rates at a record-breaking pace without regard to the inflationary consequences. Washington politicians are also alarmed. They are pushing through a fiscal stimulus package many observers thought would take months to reach the president’s desk. This combination of strong monetary and fiscal stimuli will prevent a recession from becoming too deep or prolonged.

While I remain bearish on the economy for the time being, as I explained on January 22, I am turning more bullish on stocks. I believe stocks have fallen enough to be attractive to all investors except those with very short horizons. It’s time to allocate more money to this asset class. Our recommendation of Citigroup (C) this month conveys my conviction that some of the best opportunities for long-term gains will come from the oversold financial sector.

Comments

[SchraderTrader]

At this point in time I believe it's still premature to be allocating funds to financials. Recession-level earnings haven't been priced in to firms' models yet and there may be a couple more big shoes left to drop in the sector (credit downgrades, bankruptcies). Citigroup is one of the most vulnerable to these potential downgrades and it's almost a crap shoot as to whether or not they'll get through unscathed. On a risk/reward basis, the downside risk is somewhat limited but big enough to encompass a 20%+ decline from yesterday's close. The upside risk would be missing a major move. By now investors missed Citigroup's ride from $23/share to $30/share (a 30% swing) and it has come back to ~$28. In my opinion, still a dangerous place to be recommending a stock with so much downside left to retest its previous low.

[User 124892]

The market won't be ready to buy until the banks find out the true value of what they are holding. As of now they don't know what the value is of their assets. Stocks won't be ready to buy until the Dow gets down to 7000-8000. A 40-50% decline in the Dow will lead to a bottom. Investor would be foolish to invest in equities with the current uncertainty.
There is a reason that the Bush administration wants to stimulate the market. Government just doesn't do it out of kindness of their heart.
I think it would be objective to stay out of the equity markets until after the presidential election. When the market falls it will be lighting fast.

[Long-Short Guy]

I love the title of your book. Refreshing change from the adoration of the fans.

[Reinko]

Seldom you read such a weird article.

For example since I live in Holland I have emailed a few Dutch banks with a simple to understand question:

When calculating the reserves of your bank, are the off balance items taken into account?

Until now I am still waiting for the first answer...

So Vahan Janjigian, why not email Citi with the same question. Wanna bet they also don't answer?

[hysteria]

All the pain financials have felt so far has come from only a 10% correction in nationwide home prices. Imagine the level of devestation when prices fall another 30-40% necessary to return to their historic long term appreciation and price/income trends! Buying financials now means you believe none of these historic norms mean anything and that real estate is done correcting, which is obviously false. A simple Google on ¨Case Shiller historic home values¨ shows how far we still have to fall.

[helplessobserver]

Vahan,
My view of the economy over the last year was the same as yours. I had sell stops in my managed portfolio and it is 98% in cash. Surely there is a better bank to recommend than C. It has been sick for several years and the latest bouts of turmoil makes it a basket case. Financial investors need to watch the regional banks with little or no sub-prime exposure to see how deep the credit problems are. If a bank like BBT begins retreating back to the 20s you can kiss a soft landing goodbye.

[gordon]

I'd rather put some BP away, paying a 5% dividend now, then expect banks to not go lower or cut dividends.The next bank cutting dividends crushes the sector again. Capital ratios may dictate they do.

[nyka]

...whether or not...drop the "or not"; it's inferred

[NoFate]

Why people rush back in to bottom fish when every technical indicator screams BEAR is beyond me. Why not wait for a higher low? If it is REALLY near a low then it will rattle around down here for the next year as the other sectors come crashing down around it.

I really doubt it is a low though. As others have pointed out, there is still serious unwinding ahead with housing foreclosures, other forms of credit defaulting and additional mortgage backed debt imploding (because of the first two and the ratings games).

No sir, I think we are just about getting started here. Them financial folks dug themselves a nice big hole.