Financials: Bottoms Happen When Everyone's Convinced They Won't

| About: Financial Select (XLF)

It’s of course my view that the financial stocks have made a bottom; I even have a strong suspicion the very day it occurred: July 15. And as I’ve noted here before, essentially no one else on the planet seems to agree with me. That’s life.  

Rather, the bears insist on seeing some kind of fundamental improvement in the outlook for the sector before they’re willing to invest. So depending on whose checklist you’re reading, non-performing loans need to peak and start to decline. Or net chargeoffs need to begin to come down. Or loss provisions have to fall. Something good needs to be on the horizon.

Sorry, the stock market doesn’t work that way. Remember, the market is a discounting machine: it anticipates key events so early on the vast majority of investors don’t even think those events are possible. In the case of the financials now, that means stock prices will turn higher (and already have, I believe) when most investors believe that things are still getting worse. It happens every cycle. 

So there’s no use trying to concoct your own list of mental milestones. Instead, go back and look at what happened (and in what order) during the last major credit crackup, in 1990-91. If you do, you’ll see that the bears have things all backwards. By the time their wish lists happen, the stocks will be zooming.

Take a look at the chart below. It shows banking industry net chargeoffs and loan loss provisions for the years 1988 through 1993. If you’d bought the stocks back then according to the logic most analysts are using now, you’d have dipped your toe in the water maybe in late 1991, when chargeoffs and provisioning was peaking or, more likely, in early 1992, when it was clear they’d started to fall.

And how would you have done? Not too darn well. Look at the chart again, along with the chart of an index of large-bank stocks below it. As you see, by late 1991, the recovery in stocks was already nearly half over, and the stocks had more than doubled. By 1992, they’d tripled. Nice call!


Rather, the index bottomed in October 1990, when chargeoffs and provisioning were still going up. At the time, no one thought things would get better anytime soon, (they were right!) the same way no one seems to think things are going to get better any time soon now. 

As I say, I believe the financials have made their bottom. Valuations are compelling, and the companies’ earnings outlooks have at least begun to stabilize. In particular, in the quarter just past, the inflow of new problem loans began to fall, and the rate at which early-stage delinquencies rolled into later-stage buckets declines. That’s what the beginning of an improvement looks like. Investor anxiety, meanwhile, is at a peak.

Eventually, these small glimmers of improvement will lead to what the bears say they want to see: a decline in problem loans, say, or declining net chargeoffs. The problem is, by the time that happens, the stocks will already have soared. 

Last cycle, smart investors began buying at the first, tentative signs of improvement. That’s what smart investors should be doing now, too.

Tom Brown is head of