Merrill's Muddled Analysis: Another Reason I'm Bullish on Financials 17 comments
Tom Brown
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I wrote here last month that July 15 would likely turn out to be the bottom for the financial stocks, I’ve been encouraged, believe it nor not, that the vast majority of industry analysts disagree. They see the stocks’ rally as just a bounce in a bear market that will never end. If anything, the bears are more bearish than ever.
Not to mention more popular. Have you read the ode to Meredith Whitney that’s set to appear in the upcoming Fortune? It runs 4,200 words and includes the sorts of details that might turn up in a People magazine profile of Angelina Jolie. (“She recently gave up coffee, and she works out twice a day, often under the supervision of rapper 50 Cent's personal trainer . . . ”) And, yes, it’s the cover story. You will have your own as to when the turn in the financials will happen, but you’ll have a tough time denying that this is the exactly the sort of financial journalism that only gets published near market extremes.
(And, as I say, maybe the extreme has already passed. Wachovia’s stock, for example, has jumped by around 90% since Whitney downgraded it to underperform three weeks ago.)
Then there is the note the banking team at Merrill Lynch published earlier this week: “No reason to turn positive past 2Q earnings season.” It is the picture of rear-view-mirror analysis—and typical of what’s being turned out by the sell-side these days.
“We will see another 28% downside risk for the group,” they write. Don’t you love that precision? Actually, a 28% decline in the stock prices of the names in their universe wouldn’t take the stocks’ prices meaningfully lower than they’ve already been. Maybe Merrill is calling a bottom, too, but just doesn’t realize it.
The Merrill team then lists three reasons why it believes the recent rally is unsustainable. None are convincing, in my view:
- “Stocks won’t bottom until problem loans peak, and we are a long way from these levels.” In fact, the Merrill crew has things precisely backwards. In the bear market of the early 1990s, problem loans didn’t stop rising until nearly a year after the financials bottomed in November of 1991. The Merrill analysts shouldn’t be looking at the absolute level of problem loans, but rather the rate at which problem loans are rising—the so-called “second derivative.” And on that score, the news is encouraging. At one company after another last quarter, the rate of inflows of new problem loans declined, even as companies larded on big additions to their loss reserves. That’s what the beginnings of a fundamental turn looks like. Yet the stocks’ valuations’ seem to be discounting a credit crackup that will last more or less forever.
- “Valuations are still high compared to historical average and current returns.” Valuations high compared to “current returns”? By that standard, Merrill Lynch won’t turn positive until investors get paid to own the stocks. With respect to their first point—that valuations are high versus the historical average—much is lately being made of the fact that banks’ price-to-book ratios are still meaningfully higher than they were at the lows of 1990. Take a look at table below, and you’ll see:
Price-to-Book Ratios | ||
| Sep, 1990 | Jul, 2008 |
First Quintile | 1.16 | 2.39 |
Second Quintile | 0.84 | 1.60 |
Third Quintile | 0.73 | 1.29 |
Fourth Quintile | 0.58 | 0.95 |
Fifth Quintile | 0.36 | 0.56 |
Source: S.C. Bernstein |
| |
But if you look at the relative price-to-book ratio of banks now versus the last bear market low, we’re pretty close. Here’s the data:
Relative Price-to-Book Ratios | ||
| Sep, 1990 | Jul, 2008 |
First Quintile | 0.70 | 1.00 |
Second Quintile | 0.51 | 0.67 |
Third Quintile | 0.44 | 0.54 |
Fourth Quintile | 0.35 | 0.40 |
Fifth Quintile | 0.22 | 0.23 |
Source: S.C. Bernstein |
| |
- “The group will unlikely bottom until historically high volatility subsides.” The Merrill analysts don’t exactly define what they mean by a “bottom” here. Is it when the stock prices hit their absolute lows (which is my definition and, I presume, everyone else’s), or is it when Merrill Lynch’s analysts finally sound the all-clear?
Regardless, the Merrill analysts must surely know that stock price volatility is often at its highest at precisely the moment of market turns. (August, 1982 is perhaps the mother of all examples of this phenomenon; this past July 15 saw heavy volatility, as well.) Combine the extremely depressed valuations of financial stocks with the high short interest in them, and I don’t see how the turn can’t be accompanied by huge volatility. Of course, once people realize the turn has happened, volatility will be seen as a good thing, not a bad thing, and Merrill’s analysts won’t be so eager for it to go away.
Concerns
In their report the Merrill analysts raises three other concerns about bank stocks: a) earnings expectations are too high, b) credit will continue to worsen, and c) capital concerns will increase.
With respect to earnings and credit quality, those were lagging indicators the last credit cycle and I expect them to be so again this time, too. The market is forward-looking; at inflection points, it doesn’t much care how last quarter’s earnings or chargeoffs turned out.
As to the concern that possible future capital raises might somehow become more difficult because participants in prior raises are now underwater, somebody please buy these people a newspaper. Their own firm just raised $8.5 billion at $22.50 per share after raising $12.8 billion in December and January months at at around $48 per share. So yes, it can be done, and without too much trouble, either.
Reasons to be Positive
As I say, I believe the bear market in financials ended on July 15th. That doesn’t mean every day from now on, the price of every financial will move up. But I do believe that, in aggregate, the lows in financial stock prices have been reached.
Unlike Meredith Whitney and the crew at Merrill Lynch, I’m optimistic because:
- The rate of credit deterioration has slowed, as measured by the inflows of new problem loans.
- Lenders are aggressively charging off loans and adding to their loss reserves.
- “Core” earnings power has been maintained at most institutions, and even enhanced at some.
- Company stock valuations reflect a dramatically more severe and prolonged economic downturn than is consistent with most economic forecasts.
The consensus of analysts and the media is that the bounce in financial stocks since July 15th is just that: a bounce. I believe it’s the end of a bear market and the beginning of a bull market. It’s time to buy the stocks.
Tom Brown is head of Bankstocks.com
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This article has 17 comments:
What about 'normalized' earnings? the past 4-5 years saw bubble earnings -from a credit and derivatives bubble. What di you think will these normalized earnings look like? and will bank stocks still look attractive in the light of these forward normalized earnings? I very much doubt it. This is a financial bubble bursting, not a cyclical downturn á la 1990. this is the real deal this time.
may it be that you just happen to be overly optimistic (confirmatory bias anyopne)?
Maybe Tom should have waited until FRE reported this morning.
They again confirm, what will continue to be confirmed for the foreseeable future. A long chain of interlocked losses:
Homeowners are in debt up their eyeballs and keep defaulting.
Businesses in turn are suffering.
The insurance, derivatives, MBS instruments and everything else associated with those contracts keep getting destroyed in value.
Companies cant raise cash fast enough to match the declines.
The leverage of 20:1 in some cases makes everything that much worse.
All this coupled with an economy that has been slow and getting slower (regardless of the manipulated govt data we see- and yes folks we all know its manipulated).
Tom will be right at "some point". From his point of view he has to be for his sake. He needs to be right. Again when your a hedge fund manager of a long only financial hedge fund you better be right sooner than later.
Plus, she is smarter and better looking. Probably richer too, if Tom has been "eating his own cooking" in his long-only hedge fund.
It is no wonder he is jealous.
In the 1980s bank crisis we had 747 failures.
And they call this one the worst since the Great Depression.
They will eventually have to call this one the Great Misconception.
The problem with some of the folks reading SA.. well, they just want the sky to fall so they can say " I told you so ".
I agree with Tom.. I think he is correct in his view point and time will prove him out. Keep up the good work.. thanks.
Lets face facts - the selloff has been overdone, and the only people baying for blood are those who did not see this coming and have made hefty losses. I feel sorry for you, but that is part of the game. Investing involves risk.
The situation may not be pretty, and the moves MER is taking to extract themselves out of the mess may equally be unsavoury, but at least they are tackling the problem and working hard to restore shareholder value.
When all is said and done, I bet almost anything that the SP will at least double this (at present $26) in under two years time.