Tuesday: Turning Point in Our Financial Crisis?

Well, the Olympics have begun and oil is down 22% from its all time high.

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As one would expect, this was welcomed with open arms (the consumer may be saved from demand destruction, the Fed can keep rates at 2%). The rotation out of all things pertaining to commodities (oil, agriculture, metals) have provided an interesting situation: there is now nowhere left to hide, and there is nothing which is untouchable from the downward trend of the broader market. In other words, there are no bullish "momentum" stocks to park your money in, as all of those have gone into free fall at one point or another, and have since stabilized at a lower price. At the same time however, because of the fall in oil, there have been some unfounded gains in certain places (chiefly anything financial), until yesterday!

If you notice from the chart, financials have sort of, drifted higher recently. The rally which occurred after the bottom on July 15th was sustained because of the simultaneous drop in oil...The only thing is that, some day oil will also stop falling, and will stabilize. Many say that will happen at $110/barrel. I think that is a sound prediction, but believe that it can be around $85-$95 through the winter. Winter is 4 months away though, and once oil stabilizes, the hot money has to go somewhere. More importantly, there won't be anything fueling the rally in financial services, because they are still in horrendous shape.

Finally, the prediction...

I think the saying "markets do not repeat themselves, but the rhyme." applies to our current situation. In case you have repressed this information (I did, until today) the last sell off in financials was sparked by none other than a series of downgrades...on Tuesday, we had another round of downgrades and cuts in earnings estimates (Goldman (GS), JPMorgan (JPM), Morgan Stanley (MS)).

While we do not have as negative a catalyst such as rising oil prices, we do have, what I believe to be a drying pipeline for good news now that commodities have dropped big. This also means that Financials are in the spotlight because they can no longer share the blame of a bad environment with high oil prices. TO TOP IT OFF, a more severe catalyst for financial services can emerge, and that is the deterioration of banks like JP Morgan, which have been virtually unscathed...until Tuesday. If they were believed to be the fortress from this whole mess, and they come out in bad shape through 2009 (which was picked up by their press release, hence the biggest drop in 6 years) we can see a serious sell off.

Finally, by now we must know that the news of Merrill Lynch (MER) selling their CDOs was a bad sign, not a good one, and John Thain might go down as one of the worst CEOs in finance history because of it. Not only did he sell the pre-2006/2007 CDOs - which represent the better quality basket simply because debt from that time frame is more likely to get paid back - but the good CDOs within that tranche were undoubtedly cherry-picked by the guys who bought them. (Honestly: if you were spending billions of dollars on such a toxic investment, wouldn't you make sure you got the best ones?)

The inevitable realization of losses in Level-3 assets/off balance sheet assets, coupled with instability amongst the bulge bracket banks going forward, will result in another sell off, and another bottom (no one can really say if it will be worse than the last one, and I surely won't begin to speculate).

One can either watch this happen again, or make an inconvenience an investment opportunity. SKF, an ETF which shorts financials at 200% the inverse, traded at $120 on Tuesday, and I will be buying on any pull back. Its high (or the financials' bottom) occurred at $211. If we experience a less severe sell off, we probably still get to $160. That's a 40 point spread, and a 33% gain.

Disclosure: None

Comments

[venividivici:]

I think your analysis is spot on. But I don't like the idea of shorting anything. I prefer to park my money in a 24 hour at call money market account which is yielding close to 8% here in Australia. And wait for all the smoke to clear.

2008 Aug 13 08:05 AM

[irondoor91:]

Nice article, but it doesn't go far enough to address what will happen to all the regional and smaller local banks that have half their assets in either A&D real estate loans to small local/regional undercapitalized developers and builders. Usually, the only collateral backing those loans is the land/houses themselves and/or the balance sheets of the developers/builders. Care to guess the assets of those borrowers? If you said more real estate, personal residences, trucks, cars, boats, airplanes, motorcycles, vacation homes, etc. I know many of these guys and they are on very thin ice right now.

When the banks tighten credit, the water goes out of the bathtub and the banks slowly cut their own throats. Maybe they're hoping to be the survivor and gain future market share.

By the way, where are the rest of the bank assets invested? Try more government securities, most of which are backed by real estate loans.

2008 Aug 13 10:43 AM