28 October 2009

A virtual interview with the WSJ and the FT - Part 1

WSJ: We read with interest your views on the origin of the financial crisis we went through: In a recent article you were indicating that you would prefer to be short instead of long in the banking sector: why?

M&B: The crisis that started in August 2007 is the abrupt adjustment to 20 years of over-indebtedness: over indebtedness by governments, individuals and corporations (to a lesser extent), thanks to central banks having provided plenty of liquidity, particularly in the US. Each time we had a crisis, the liquidity ticked up, and we had such crises more often over the past two decades and they became more acute and important in size. No decision was made to go to the root of these crises: over-liquidity leading to the misallocation of resources. Besides a loose monetary policy, these crises were also spurred by bad political decisions.

Is there anything new? No. The G20 in London focused on tax havens and in Pittsburgh on traders’ bonuses. Wrong, these are meaningless vis-à-vis the current crisis and its causes even if they do the front page of media and are talked up by politicians. These are pure scapegoats to deflect the attention of the public from the real roots of the problems and solutions that will be painful.

Regarding the banking industry, I do not believe that problems are healed. True, a collapse has been avoided and this is fine; we gained time, very important in troubled times. Many banks received public money, and many have repaid it. However so called toxic and non-performing assets are still in their balance sheets (or off balance sheets) and their value has not improved (home values not really increasing, credit card delinquencies on the rise, commercial real estate starting to hit, to name a few). Bank’s lending continues to go down, so the real economy is not getting the financing it needs, particularly small and medium businesses (loosing 50k jobs 10.000 small business is politically and journalistically irrelevant, loosing the 10k jobs via GM is important, this is the power of communication and making “events”).

Many banks have returned to profits, but a lot has to do being financed at close to 0% whilst investing the proceeds in Treasuries yielding +/-3 % - a no brainer to make money by the way. The core business of banks (or what it should be) is not improving at all.

Look at Q3 results at JP Morgan Chase in details – one of the best managed banks. Net profit $ 3.6 billion: 7X Q3 2008 and +32 % / Q2 2009. Great! But hold on, look at the details. Over 50% are coming from investment banking (and over 2/3 of Investment banking revenues coming from trading profits). Retail financial services are hardly making any money ($ 7 million profits) and the situation is deteriorating compared to previous quarters with provision increasing (nearly $4 billion representing nearly 50% of net revenue). Card services losses are mounting: $ 700 million (close to $5 billion provisions) vs. a Q2 $ 672 million loss and a Q3 2008 $ 292 million profit (if I however do not dismiss the ability of the management to "overcharge" provisions to reduce the effective tax rate and create a cushion for the future and smooth results, in this case I believe the assessment is real). The rest of business lines is more or less flat.

And what about Goldman Sachs – the best fully-fledge investment bank – where 70% of its net revenues are derived from trading at $ 8.8 billion during Q3? Net common equity stand at more or less the value of level 3 assets (the illiquid difficult to value assets). From what I read, Goldman Sachs is also back to the happy days of leveraging (15X from my rough calculation of common equity/total assets - it is beyond the purpose of this interview, but I would be quite interested to know the ratio with off balance sheet items...). We are back to a Return on Equity (ROE) above 20%: I thought we were in a new world... Never mind, the tax payer bails out, and management retains their position with no financial sanction (the only one that really matters, besides jail).

A final word on commercial banks and subprime mortgages. A recent study published by the US FED showed subprime borrowers represented 20% of all new mortgages in 2006 to zoom down to zero in Q1 2008 to reach... 20% currently in an environment where net lending is negative for the first time since 1970.

All this led me not to be optimistic about the banking sector, bearing in mind that deleveraging will translate into lower ROE and lower valuations (just look at the collapse in private banking valuations that went from 6-8% of AUM some years ago to 1-3% now).


Goldman Sachs

JP Morgan Chase

Federal Reserve Bank of St Louis

Federal Reserve Bank of San Francisco
Economic Letter: Recent Developments in Mortgage Finance

26 October 2009

Chart of the Day

For some long-term perspective, today's chart illustrates the Dow adjusted for inflation since 1925.

When adjusted for inflation, the bear market that concluded in the early 1980s was almost as severe as the one that concluded in the early 1930s.

The inflation-adjusted Dow is now a little more than double where it was at its 1929 peak and trades a mere 51% above its 1966 peak – not that spectacular of a performance considering the time frames involved.

It is also interesting to note that the Dow is up 54% from its March 9, 2009 low which is actually slightly more than what the inflation-adjusted Dow gained from its 1966 peak to today.

18 October 2009

Chart of the Day

Despite a host of concerns (weak economy, high unemployment, mounting foreclosures, geopolitical issues, etc.), the Dow made another post-crash high today. While the recent string of new rally highs is significant, it should be noted that the Dow is currently testing resistance (see red line).

Liquidity is still abundant and flowing to investing asset classes more than to the real economy. The dichotomy between the real economy and equity markets is widening.

09 October 2009

The magnificent 7 and equity markets - Review 4

For the past 3 months, equity markets have continued to forge ahead unabated. The magnificent 7 are telling us that there is no reason for the markets to pause beyond short term overstretched valuations (I recommend the reader to go to the GTI web site for their monthly newsletter, one of the best available).

S&P 500 Banks index: the index has now been consolidating for 2 months around the 130 level. The index continues trading over the 200 days moving average which in turn is near its inflection point and on the brink of becoming positive. Results fro banks should be positive for Q3 and any disappointment should be limited around the 200 days moving average. The new support at 128-130 is holding very well. Positive.

Global 1200 financial index: The world financial sector broke through the 800 cap mid-July to gain +/- 25% since. The new cap/consolidating zone is around 1000. The index looks more over-extended than the S&P 500 Bank index (but also with better fundamentals due to emerging markets not plagued by the sub-prime and the-likes debacle), standing well above its 200 days moving average; the latter is however firmly on a positive slope, technically favorable. Positive.

TED spread (LIBOR USD 3 mth - US 3 mth T-bills): The spread is back to normal - no stress showing at +/- 20 basis points (0.20%). Positive.

USD bank BBB 10 yr - US 10 yr yield: Whilst still high and above historical average, the spread has decreased by 1.5% since our last review in August, and now stands at 5.4%. Positive.

OEX volatility: OEX volatility is now hovering around 25% well below the stress times of Q4 2008 and Q1 2009. Ideally, I would like to see it at 20% or below. Positive.

S&P Case Shiller house price index (source: S&P): The latest data (July) published in September show the 6th consecutive month of yoy decrease in the rate of decline. More importantly, the index continued to increased:

Composite-10: July 2009: +1,7%, y/y: -12,8%
Composite-20: July 2009: +1,6%, y/y: -13,3%

Signs are becoming more positive. Slightly positive.

Oil price: For nearly 3 months, oil prices have been trading in a narrow $65-75/b band , the latter seeming to be the resistance. This range will last as long as the economy in the US is not decisively improving (watch retail sales numbers). When it breaks upwards, it will rally very sharply. Positive for the time being.

Conclusion: All these indicators are now positive for the first time since 2006. I am not (yet) in the camp of the commentators that see a bear market rally. I however expect a 20-25% correction in equity markets by 2010 Q1.

In my last review (11th August), I advised to relax and wait for the next move, expecting a consolidation that did not occur beyond a few percentages in July. Liquidity and strong anticipations are very forceful factors that have driven markets higher. I still believe that they went ahead of themselves and will very carefully watch retail numbers as well as the employment situation (whilst a lagging indicator, in the current crisis, I think it is important to follow it due to its strong psychological effect on consumers).

I however do not forget that banks' balance sheets are still fragile (look at all the capital increase announcements in Europe for example) and may be hit by commercial real estate write-downs. In that case I would change my view and become bearish. I will watch the bank index regularly for any clue about a possible repeat (whilst not as large) of last year collapse.

03 October 2009

Chart of the Day

Friday, the US Labor Department reported that nonfarm payrolls decreased by 263,000 in September. Note how the number of jobs has steadily increased (top chart) over the long-term. During the last economic recovery, however, job growth was unable to get back up to trend (first time since 1960). More recently, nonfarm payrolls have pulled away from its 50-year trend by a record percentage (bottom chart). The number of US jobs is currently at level first seen in early 2000.