Predicting the Financial Sector Rebound

By Karim Rahemtulla

Some would say that the Financial sector currently resembles animal waste. It’s certainly emitted an overpowering stench across Wall Street in the past year. And like animals fighting for survival, it appears the players have begun to turn on each other.

On Thursday, Goldman Sachs (NYSE: GS) downgraded one of its fellow financial sector members, Citigroup (NYSE: C), slapping the rare “Sell” sign on the company. But Goldman wasn’t done. It went a rather shocking step further and actually advocated shorting Citi as well, as it cut the target price on Citi from $20 to $16. The decision was part of a “pair” trade in which it suggested investors sell Citi and buy Morgan Stanley (NYSE: MS).

The news sent Citi shares tumbling to a 10-year low, hot on the heels of Goldman’s prediction that Citi will write off a further $8.9 billion in debt for the second quarter. It also projected a $0.75 per share loss for Citi during the current quarter, compared with its earlier forecast of $0.25 per share in profits. The full-year loss could total $1.20 per share, versus an earlier projection for a $0.30 per share profit. And in turn, that could force Citi into its second dividend cut this year.

That’s one heck of a downward revision.

Admiring the scrap from afar, Wachovia (NYSE: WB) then decided to jump in and issued a “Sell” on Goldman.

Like a farmer fertilizing his crops, the financial sector is spreading its muck far and wide. Other analysts, including Banc of America Securities also project a $3.5 billion second-quarter loss for Merrill Lynch (NYSE: MER).

Goldman, of course, goes a step further, pegging a $4.2 billion second-quarter write-down for the firm. So what is an investor to make of this?

Wanted: $65 Billion

One week ago, Goldman analysts declared that American banks need another $65 billion in capital to handle the fallout from the credit crunch that has inflicted a savage beating on the sector - and isn’t expected to peak until 2009.

William Tanona, the Goldman guy responsible for the Citi downgrade and short sell recommendation, has downgraded the entire brokerage sector from “attractive” to “neutral.” He states that the recovery will take a long time because fundamentals have been clobbered.

But if you look across the financial sector board, there’s a very interesting development occurring — one that is eerily familiar to the last big US sector blowup…

History Repeating… From Dotcom Dogfight To Financial Fracas

Towards the end of the dotcom collapse, all the big names that had been flying high and puffed themselves up at the beginning of the boom, then throughout the rise, started to issue downgrades and sell recommendations once the mess began to hit the fan.

It was the very definition of capitulation.

What’s odd, however, is that the very definers did not heed their own advice and turned on each other (and subsequently capitulated) at the wrong time.

And it’s happening again - except this time with the financial sector.

Most of the big financial firms are issuing “Hold” or “Neutral” recommendations on each other (in investment lingo, these verdicts are merely soft terms for a “sell”). In some cases, like we saw Goldman do on Thursday, they’re issuing full-on sell recommendations.

Bottom line: The current rout in financial sector shares might smell awful to the simple onlooker. But smart investors should know that it smells like the beginning of the end of their collapse, too.

I took a look at the beaten-down financials after Goldman issued its downgrade and “sell” recommendation on Citi and some of them actually rallied a little. What does that tell you?

Don’t look to the big name, attention-seeking analysts to tell you when to buy. Instead, turn to them when they tell you to sell. That’s when you’ll know that the bottom in financials is near.

Disclosure: none

Comments

[User 206329]

From your lips to God's ears.

[Arohan]

Well written. I would be wary of shorting any financials right now. Some sense is coming back to the credit markets and it will not be long before some of the companies start writing up their assets that were written down too far

In any case, all this is relevant only if you are looking for the short term. Longer term, financials are terrific values right now. I can't see a world where financial sector is not relevant, neither can I see some of the premier names today disappearing.

[Brandon]

There's one major problem with your thinking. No one seems to know what will happen next including the companies themselves. Even Citibank doesn't know exactly what some of its assets are worth. How can anyone be a buyer of this stock with that in mind?

Normally when a company gets destroyed like this, value investors can figure out the book value of a company and assign a fair value, in their eyes, to a stock. How can you do this with Citibank?

The bottom line? Citibank could be wildly undervalued or wildly overvalued. That's an awful amount of risk long or short.

[DRamses]

I don't think we need to even pay attention to what the analysts have to say on this issue at all. Few, if any of them, got ahead of this downward spiral and as stated above no one, including the company operators themselves knows what their assets are worth. If I'm not mistaken, unknown companies riding on the hope of their potential are listed on the pinks, or are going to market in an IPO. We're talking about the world's largest bank whose assets are not defined by them but by a market they cannot control or influence. How much would ou put on a lottery ticket, because I'ma fraid that this is what Citibank has become. Granted 20 years from now this will have been a great buying opportunity, but do I want to wait 20 years to potentially double my money?!? Who is to say that 20 years from now the business that Citibank is in will even be viable? Wide sweeping institutional change could take place, will Citi adapt and survive? Yes, far flung questions, the point I'm trying to stress is every fundamental aspect of this company is now an unknown, between new leadership or lack thereof and a changing regulatory landscape who knows what this company is worth or where its going.

[C.Elder]

Clearly we all agree that the analysts don't know anything more than we do.For those with short memories Whitney was pushing Bear Stearns as a great company a year or so ago!.So we should ponder why the analysts are slamming other banks?A few ideas for us to think about-it distracts attention from their own institution(note Whitney always slammed someone else just as her own parent co.CIBC was announcing horrendous problems);are these analysts truly independent?Or are they issuing statements to generate more volume of trades that their companies make money on regardless if the stock goes up or down?Note that Citi is the most heavily traded stock in the DJIA,and has been for months-does this make any sense in an economy as big and diverse as America's?Surely industrial companies should dominate the DJIA trading volumes?Well, they don't.It's good old Citi,and this is fueled by...you guessed it the analyst reports;and where do all those volumes get traded...you guessed it,the brokerage companies.As for Goldman's,everyone knows they compete with Citi across the investment banking spectrum,and anything that does Citi down is good for Goldman's.
I wonder though why Citi does not cut its credit lines on Goldman?Without these Goldman would soon disappear.
Anyway,just some thoughts for you all...

[Dudley]

"Echo - that babbling gossip of the air."

Thank you all for the insightful disquisition. I think what we have here are echoes. I am positive of one thing. The FED will screw non institutional stockholders by allowing PIPES and hedgefunds to reap bonanza's. Of course this will all be in the interest of "disclosure" of "real value." Most people pay their home mortgages. The subprime "mess" is a fictionalized media event that is compounding upon itself. My comment sirs is submitted with the simple and humble perspective of a perrenial optimist who has often paid the wrong price of admission.

[bode]

well, this may be the bottom for some financials. but WB has a book value of about $75B at ye07 and a market value of appx. $32B with a required goodwill write-off of $30-40B looming this year. when that happens all bets are off and the Feds will auction off Kenny's pretend bank.