Bill Miller vs. Meredith Whitney - Why They're Both Right

Includes: C, KBE, WFC, XLF
by: Andrew Corn

Throughout the credit crisis there has been an uncertainty in the air causing unwillingness, by many, to take a firm position on whether to be bullish or bearish on the market and particularly, the financial sector. Two high profile exceptions to this silence are Bill Miller, the outspoken bull of financials who is the portfolio manager at Legg Mason’s Value Equity Fund and Meredith Whitney, the former Oppenheimer analyst who gained celebrity status after she predicted the crash of financial sector stocks and who recently started her own firm, Meredith Whitney Advisory Group. You may be wondering how I can view both a bull and a bear as being correct at the same time about the same sector. The answer is that this is not a fair game nor is there a level playing field. The game is rigged, at least for now by the effects of government intervention on a global basis.

Let’s start with the bear view: Meredith Whitney’s reputation as a financial sector oracle began in October of 2007 with her remarks concerning Citigroup’s (NYSE: C) balance sheet worries. Since her famous call the financial sector (NYSE: XLF) has declined over 60% and Citigroup has not closed above $40 per share since. Also, since her call, a total of 61 financial institutions (25 in 2008 and 36 in 2009) have failed according to the FDIC many of them banks, some followed by SPDR KBW Bank (NYSE: KBE). She has described financials as “grossly overvalued” and claims that the earnings power of these banks are “negligible.” The economic climate, the housing market, and the recent credit card reforms enacted by the Obama administration all make Whitney’s argument reasonably convincing. Housing prices have fallen 32.2% from their peak and 19.1% in the first quarter of 2009. GDP declined 2.6% in the first quarter of 2009 and the unemployment rate probably jumped from 8.9% to 9.2% according to a survey recently conducted by MarketWatch. Clearly, things could be better, but will they get any worse? Have we reached bottom yet? Whitney doesn't think so.

It is time to look at the bullish case: Bill Miller thinks so.

Bill Miller had beaten the S&P 500 for 15 consecutive years until a series of underperformances in 2006, 2007 and 2008. He is an outspoken bull on the financial sector. Here are some excerpts from a May 14 article by Dan Weil that caught my attention.

"Banks, in fact, are flush with cash, have deposits flowing in, and have $800 billion of excess reserves on deposit at the Fed,” he writes in his quarterly note to investors.

"Most of the big banks that have reported results recently are profitable (Wells Fargo (NYSE:WFC) had record profits), and most improved their capital ratios."

To those who pooh-pooh the profits, such as superstar bank analyst Meredith Whitney, Miller says, "Not surprisingly, the same analysts who expected the banks to report losses in the first quarter dismiss the earnings as due to nonrecurring items, unusual market conditions (very wide spreads) and accounting gains.”

But “when those same conditions led to large losses being reported last year, those losses were considered all too real,” he points out.

Miller makes some interesting points. The unconvinced ask; how real are the earnings? Will the market and the economy recover? Will deals return along with underwriting fees? It is a reasonable possibility that financials are not nearly as bad as they were at the end of Q208; for starters, people have stopped using the term “Armageddon” to describe the situation in the sector. The modification of FAS #157 (mark-to-market) should prevent (or postpone and smooth out) “paper” losses for the banks, and the large spread due to abnormal market conditions should continue to keep margins wide in lending activities, creating a potential for a profitable second quarter.

There are also economic data that indicate more favorable market conditions ahead. Single family building starts increased by 2.8% from 356k to 368k, and single family housing building permits also increased from 360k to 373k, suggesting that although these are very small gains, the numbers appear to have stopped falling rapidly and a bottom may be near in the housing market. There may be a modest increase in home construction activity. However, I recognize that home construction activity remains at near a decade low.

US consumer confidence data rose sharply in May to 54.9 from 40.8 in April, its highest level in 8 months. Interestingly enough, if you listened to Miller three months ago ending May 26th, you would have made 48.09% if you invested in the financial sector (XLF). The sector has literally melted up.

Maybe banking analysts, considering the events they just witnessed in the financial sector, are not ready to believe any good news from the banks just yet.

I am following interest rates inching up and the bond vigilantes pouring cold water on the holy grail of mortgage rate targets: 4%. Mortgage applications rise and fall rapidly these days, a trend is yet to be had. Gas price are rising again, another head wind.

I attended the Fitch Ratings Global Banking Conference in New York last week. Three big take-aways from David Riley’s presentation on “The Financial Crisis, Policy Response and Sovereign Credit Risk” are:

  • Banking crisis and recessions feed each other, especially if international

  • A delay in restoring the financial sector health is costly for the economy and taxpayer

  • Monetary and fiscal policies must be supportive of the real economy

The government seems to be on the same page, as Fitch suggests, as the old Goldman (NYSE:GS) boys, oh I mean Washington boys, read the same charts and thankfully are students of history drawing similar conclusions. Their efforts, coordinated on a global basis, may drag the US economy and the world out of recession as soon as the end of this year.

Miller is right as we have seen a melt up in financial stock prices from record lows. Whitney is right that there are still billions in toxic assets on balance sheets and with some institutions, off the balance sheet in special purpose entities.

As a portfolio manager, I predict that the short term for the financial sector will be characterized by volatility. Investors are anxious and uncertain which will cause news and commentary to move individual stocks rapidly but with government support, not necessarily the sector as a whole. Overall volatility will decrease over time, looking towards Q409 and Q110, but idiosyncratic risk will remain for some time.

Profits or losses, second quarter earnings will cause stocks to move. Individual companies will be greatly punished or rewarded for their performance, yielding a PR victory to both Miller and Whitney. The government will continue to prop up firms deemed too big to fail or vital to specific regions or industries.

For the long term, ultimately, I am bullish on financials. As the Fitch presentation suggests; without a strong financial sector economic recovery will be fleeting. This sector needs to lead the economy out of the recession and the individual financial companies that have real earnings, manage risk and their current books well, and are able to raise adequate capital will be well positioned for large gains.

Shout out to intern Andrew John Vanloon for assistance with this post.

Disclosure: Mr. Corn is Chief Investment Officer – Equities of Beacon Trust Company. Beacon Indexes (formally Clear Indexes) designed and publishes the index tracked by Claymore/Clear Global Exchanges, Brokers and Asset Managers ETF (NYSE: EXB). Through various equity strategies under his supervision Mr. Corn is long stocks in the banking and insurance industries as well and other types of financial institutions.