Daniel Eskin's  Instablog

Take a closer look at the biggest loser (and recently gainer) within the market in the YTD – the financials industry. Take, for example, the DJ U.S. Financials Index (DJUSFN), which is now about 120% higher than its lows from March, higher than any other industry index. It’s interesting how quickly human perceptions can change based on greed and the desire for quick profits instead of a long-term based investment mentality.

When the whole “crisis” occurred, the companies whose stocks got hit the hardest were those with wobbly balance sheets teetering on the edge of a mountain of debt – mainly, the financials. The DJUSFN dropped 50% from January 1, 2009 to mid-March, 2009. Subsequently, the government and Bernanke stepped in and started chopping interest rates, leading to additional capital flows into the market, and guess where they went? Massive government support artificially propped up the financial sector.

Human nature was exhibited again, and just like investors rushed out the doors from financials, they now rushed back into financials which experienced massive drops and were up for grabs, giving many financial stocks arguably the highest gains since March to date. For example,Genworth ( GNW 11.05 ↓6.28%)GS is up over 1000% (from around $1 to now around $12), Las Vegas Sands (LVS 17.74 ↑0.11%) LVS is also up over 1000% (from $1.50 to now about $17), and even a bigger player like Sachs GS (187.23 ↓1.54%) is up about 140% – gains investors and traders dream about at night.

(Honestly, I just wanted to portray this graph to let you feel the rush from seeing that you could have multiplied your money by 10 – exactly what traders have been feeling in the last few months. It’s easy to get sucked in.)

Look at Japan in the early 1990’s. After Japan’s asset bubble burst, the government dropped interest rates lower and lower towards 1994 (from above 8% to under 4%). The initial plan was just like the current Fed plan – to keep interest rates low for just a little bit… which turned into a little bit more… which turned into as long as necessary. Now Japan’s interest rates are sitting at around 1%, but the supposed hidden agenda behind the low rates was to recapitalize banks, despite the detrimental effect it has had on the country for the two decades and causing a weaker Yen. It’s reasonable to believe that the Fed has this hidden agenda as well; a fundamental question in their mind is now that banks have wiped out a lot of their capital, can and will the banks be recapitalized? Low interest rates help contribute to that recapitalization.

Another good example is Volker – renowned as the greatest inflation fighter of our time, who raised interest rates to a high of 20% in June 1981 in an attempt to avoid inflation. This move conquered inflations rates of 13.5% (1981) to a much more reasonable 3.2% (1983). Obviously, such high interest rates have their own repercussions, but are arguably not as detrimental to the economy as stagflation. The positive effects of this rate increase on the market can be evidenced as follows:

What happens now? As a lot of you heard, Fed governor Kevin Warsh, supposedly a close advisor to Bernanke, cautioned that Fed Policy in the near future would be taken with “great force than is customary”. This quote has been repeated in the last week or two countless times to the extent that it even may be creating a self-fulfilling prophecy. Just to clarify, Warsh is pretty much admitting that Greenspan screwed up by keeping interest rates too low for too long in the past, and even though the Fed has kept rates low for the last little while, they would be raised right back up before they caused more harm than good. Maybe the Fed is hoping that even the comment itself is going to create a more controlled recovery in the economy… regardless, I just hope that they know better than Japan did and don’t keep rates low “for as long as necessary” because the inflationary ramifications of that are immense as well… Germany in the 1950’s? That’s an exaggeration, but you can see what I’m trying to go for.

Regardless, I guarantee that when (and if) the Fed suddenly props rates back up a few points, financials will be the sector that gets hit the hardest. Honestly, I don’t know if I would have had the discipline to maintain a long term perspective in the last few months since it’s so easy to get lured into the quick gains that traders were prospering from, but I sure as hell would get out of financials right now.

Something big is brewing in the United States and everybody is feeling the uncertainty.

Disclosure: no positions