Coming Bull Market in Financials: A Few Items Portending the Turn

Aug.24.08 | About: Financial Select (XLF)

Have I mentioned I’m bullish on the financials? In case I haven't, here’s the thumbnail version why: 1) Valuations are idiotically compelling. 2) Inflows of new problem loans, especially mortgages, appear to be declining. 3) Delinquency roll rates are declining, as well. 4) Lenders have begun to liquidate their foreclosed properties in an orderly fashion. 5) The outlook for the companies, post crash, is startlingly strong.   

It’s not complicated. Even so, beyond my formal bull case, I can’t help but notice a few straws in the wind this week that have reinforced my optimism. By themselves, they’re trivial—but are just the sort of small, telling events that tend to occur at market extremes. Here goes:

Item: On’s Stockpikr site Monday, the most popular posting was entitled “Bank Stocks Headed to Zero.” Pithy! Not “Bank Stocks Headed Lower” or “Bank Stocks Likely to Weaken.”  They’re going to zero. You can’t get much more bearish than that. And Stockpickr readers couldn’t get enough of it—the article had generated over 73,000 page views, at last look, with 41,000 on Monday alone. On analytical substance, you’ll forgive me for adding, the article left something to be desired. Banks that are headed to zero, it announced, have three distinguishing characteristics:

    1. Their nonperforming loans are rising
    2. They need to add capital, and
    3. Prices of their credit default swaps are rising.  

Helpful! By those criteria, roughly 99% of the banking business will shortly be out of business. I’m not sure why anyone would—or did—find this insightful. But at this point in this market, that title was irresistible.

The unnamed author even provided two names on his “toast” list.  One is Vineyard National Bank, which is already down 95% this year, having disclosed in a filing that “conditions and events cast significant doubt in our ability to continue as a growing concern.” So our sage isn’t out on much of a limb. The other is Chicago-based Corus Bankshares, a big lender to condo developers in Florida.   

Notably, neither Vineyard nor Corus even fits the writer’s three-point criteria, since CDSs don’t trade on either one. No matter. At this point in the cycle, the last thing the bears need to demonstrate is analytical rigor.

Item: Analyst changes her valuation technique in order to keep her target prices down.
In a note she published on Tuesday, Morgan Stanley’s Betsy Graseck disclosed she’d changed her thinking on the best way to value Wachovia:

We use a variety of valuation methodologies to determine our price targets, residual income, PE/PB multiples, and sum-of-the-parts. Typically, our price targets are equal to our residual income valuation targets. For the time being, we have switched our valuation methodology to multiples. The simple reason is that residual income is based on the value of excess long-term returns over cost of capital. We expect that the next 3–4 quarters will be very difficult with deteriorating consumer losses. We expect that the market will not value longer-term excess profitability until deteriorating trends stabilize 1Q09 at the earliest in our opinion. We’ll revert back to residual income-driven price targets when we can expect to see some stabilization in consumer delinquencies and home price changes. Unless our banks give us more information on the tail risk in their consumer loan portfolios (CTLV, MSA, Vintage, FICO, etc.), we will wait until consumer trends stabilize before reverting back to our residual income valuation methodology. [Emph. added]

Translation: when Betsy writes “We’ll revert back to residual income-driven price targets when we can expect to see some stabilization in consumer delinquencies,”  she really means  “We’ll revert back to residual income-driven price targets when they stop producing price targets that don’t support our bearish views.” 

Graseck is a good analyst. She should be able to come up with reasonable parameters for estimates of losses that Wachovia’s consumer portfolio will produce over the next four quarters.  If she can’t, why does she even bother publishing detailed income and balance sheet projections though 2012?  If she can come up with an estimate of consumer losses (which she can), she can then come up with an estimate of overall operating losses in coming quarters, and in turn project how much additional capital the company needs to raise. All this can be done, not with certainty but within reasonable parameters.  When we go through the process, we find the market has excessively discounting Wachovia’s future growth prospects.

But if Graseck went through the same process, she’d come up with numbers (and already has, it sounds like) that would be so compelling that she’d have no choice but to recommend the stock aggressively. But virtually nobody is recommending bank stocks these days, aggressively or otherwise. So Graseck simply throws that valuation method out and takes refuge instead in the wishy-washy pseudo-rigor of relative valuation. 

Item: Phil Zweig reappears on the opinion pages of American Banker. In the early 1980s, American Banker reporter Phil Zweig did a great job of breaking and following the collapse of Penn Square Bank and its subsequent fatal impact on Continental Illinois.  He covered that financial crisis as well as anyone. Since then, he’s written a number of books related to the banking business, including a biography of Walter Wriston. But last Friday, the Banker trotted him out to reprise his role as in-house Diogenes, with a guest column that blames the current crisis, as well as prior ones, on—are you ready?—senior managements who don’t listen to whistle-blowing employees.  Heavy rains bring out strange things.

A Bullish Anecdote 

Not all the news lately has been overtly bearish, however. Rather, one of the most bullish developments lately has been the increase in the number of announcements by banks of sales of troubled assets.  In particular, a Midwestern regional just completed the sale of $71 million in troubled real estate credits, several Southeastern banks have reported bulk sales, and another large Midwestern regional reported that the number of serious inquires its received to buy pools of its troubled assets has increased five-fold since August began.

I agree with investor Rich Pzena, who says we will look back on this 2007-2008 time period as one of unprecedented credit disruption and losses out of which investors will reap unprecedented positive returns.

Tom Brown is head of

Disclosure: See declared holdings for fund managed by author: Second Curve Capital