In recent days, the financial markets seem to have gone gaga. Gold is approaching $1,000 an ounce again. Bank and other financial stocks have rallied. The two trends are analytically inconsistent. Gold is favored when the economy is falling apart, inflation is surging or the political situation is deteriorating. In other words, it's an investment of last resort. Bank and other financial stocks make the most sense when economic trends look rosy. Since banks and other financial institutions lend to or invest in large segments of the economy, it is logical that they would rise when the picture looks good.
When both gold and financial stocks rise, cognitive dissonance sets in. But only if you assume markets are rational and interrelate with each other. While there may be a vague and general relationship between gold and financial stocks, for the most part, they are separate venues where different opinions are expressed through trading activity.
Markets require differences of opinion to function. Someone has to prefer cash to a stock, bond, gold or what have you, in order to sell. Someone else must prefer to own the stock, bond, gold, etc. instead of cash, in order to buy. These differences of opinion are the foundation for the supply and demand that interact in markets.
But different markets don't necessarily reflect the thinking of the same people. People who think inflation is around the corner and the economy is headed for a double-dip recession are snapping up gold. But they're very likely not selling or shorting financial stocks. People who see green shoots at every turn are speculating in financial stocks. But they're probably not selling gold or shorting gold stocks. Just as there is no unified field theory in physics, there is no unified financial market. Instead, gloomier investors express their opinions in one market. Optimistic (or opportunistic) investors express their views in a different market.
If you're trying to figure out what's going on, don't look for overarching explanations of all market activity. The last three times gold approached the $1,000 an ounce range (March and May of 2008 and February 2009), financial stocks were wobbly. Now, almost irrationally, they are not. What really seems to be going on is that in the low volume trading of the pre-Labor Day vacation period, different investor opinions are being expressed in different markets. These views can't easily be reconciled. Perhaps the most they indicate is the likelihood of greater volatility in the near term future.
Disagreements are a natural part of market activity. Avoid reading a lot of significance in recent gold and financial stock price movements. Gold reached the $1,000 range three times in the last 18 months, yet mobs don't rage in the streets and the Constitution remains the law of the land. The revival of financial stocks doesn't necessarily mean that all will be well. The financial markets are heavily populated with soothsayers and diviners that attribute talismanic significance to price movements of particular investments. There is no all-knowing indicator in the markets. There's simply the usual cacophonous potpourri of humanity.
Showing posts with label Financial Stocks. Show all posts
Showing posts with label Financial Stocks. Show all posts
Thursday, September 3, 2009
Thursday, October 25, 2007
Choosing Financial Stocks in a Time of SIVs and Credit Crunches
Many large commercial and investment banks announced painful writedowns and large losses for the third quarter of 2007. Some other banks, though, have announced relatively moderate writedowns and continued earnings strength. Are the latter a good buy?
One lesson from the high tech boom of the 1990s is that when you have a distressed industry, think carefully before investing in the apparent winners. Recall the telecom industry circa 2000 and 2001. Company after company was announcing writedowns and losses from aggressive expansion and industry overcapacity. Some companies folded. But WorldCom kept announcing strong financial results. You might have thought WorldCom would be a good investment.
Fastforward to June 2002. WorldCom publicly admitted to having engaged in an accounting fraud involving billions of dollars. Those glowing earnings reports were bunk. Shareholders were hung out to dry. The biggest difference between WorldCom and the losing telecom companies was that WorldCom was willing to lie about its performance.
The financial services industry is currently living in a world of turmoil, with much of the turmoil stemming from CDOs and other mortgage-related derivatives that are traded only by appointment and often have no open market price (especially not after the credit crunch began). These “assets” are the source of a lot of the recently announced losses. Valuing them is often a matter of judgment. The bank can use a mathematical model for valuation, but there’s wiggle room in the models and they haven’t been exactly spot on when it came to predicting cash prices (see http://blogger.uncleleosden.com/2007/08/how-computers-did-in-financial-markets.html).
Only the banks and their auditors know what actually happened with this past quarter’s accounting. But here are a couple of thoughts. A bank that wanted to avoid a bad third quarter this year could have given itself the benefit of the doubt at every turn and come up with results that didn’t look bad. This would have been a dangerous tack. If the real estate sector continues to decline (as many predict), circumstances in the fourth quarter may compel more writedowns at year end. And if a bank’s writedown this past quarter was relatively small, the writedown at year end may have to be relatively gargantuan (because those benefits of the doubt tend to evaporate as asset values slide).
Of course, there’s also the possibility that a bank with a serious CDO-subprime problem may have taken the opposite approach and been highly aggressive in writing down hinky assets. Then, at year end, it might report relatively positive results for the fourth quarter. Concerns have been aired that the banks reporting large writedowns may be creating "cookie jar reserves” that they could tap into in the future to smooth out more turmoil in their earnings. If such is the case, they are likely to have a problem with the authorities, since maintaining cookie jar reserves is considered bad accounting form.
Nevertheless, if you’re going to take a flyer on a stock in a volatile sector like financial services, do you want the one that might report improvement in the future, or the one that might have spent too much time primping in front of a mirror? Is it possible that the banks reporting strong results now simply are better managed and avoided riskier plays? Yes, that’s possible, and maybe it’s true. But WorldCom was considered a well-managed company until it blew up. Think and research carefully before plunging into stocks of banks and other companies holding volatile assets.
Ironic News: a lock of Che's hair sells for $100,000. http://www.wtop.com/?nid=456&sid=1278591. The old revolutionary must be turning over in his grave at the thought that his hair might have been subjected to capitalism.
One lesson from the high tech boom of the 1990s is that when you have a distressed industry, think carefully before investing in the apparent winners. Recall the telecom industry circa 2000 and 2001. Company after company was announcing writedowns and losses from aggressive expansion and industry overcapacity. Some companies folded. But WorldCom kept announcing strong financial results. You might have thought WorldCom would be a good investment.
Fastforward to June 2002. WorldCom publicly admitted to having engaged in an accounting fraud involving billions of dollars. Those glowing earnings reports were bunk. Shareholders were hung out to dry. The biggest difference between WorldCom and the losing telecom companies was that WorldCom was willing to lie about its performance.
The financial services industry is currently living in a world of turmoil, with much of the turmoil stemming from CDOs and other mortgage-related derivatives that are traded only by appointment and often have no open market price (especially not after the credit crunch began). These “assets” are the source of a lot of the recently announced losses. Valuing them is often a matter of judgment. The bank can use a mathematical model for valuation, but there’s wiggle room in the models and they haven’t been exactly spot on when it came to predicting cash prices (see http://blogger.uncleleosden.com/2007/08/how-computers-did-in-financial-markets.html).
Only the banks and their auditors know what actually happened with this past quarter’s accounting. But here are a couple of thoughts. A bank that wanted to avoid a bad third quarter this year could have given itself the benefit of the doubt at every turn and come up with results that didn’t look bad. This would have been a dangerous tack. If the real estate sector continues to decline (as many predict), circumstances in the fourth quarter may compel more writedowns at year end. And if a bank’s writedown this past quarter was relatively small, the writedown at year end may have to be relatively gargantuan (because those benefits of the doubt tend to evaporate as asset values slide).
Of course, there’s also the possibility that a bank with a serious CDO-subprime problem may have taken the opposite approach and been highly aggressive in writing down hinky assets. Then, at year end, it might report relatively positive results for the fourth quarter. Concerns have been aired that the banks reporting large writedowns may be creating "cookie jar reserves” that they could tap into in the future to smooth out more turmoil in their earnings. If such is the case, they are likely to have a problem with the authorities, since maintaining cookie jar reserves is considered bad accounting form.
Nevertheless, if you’re going to take a flyer on a stock in a volatile sector like financial services, do you want the one that might report improvement in the future, or the one that might have spent too much time primping in front of a mirror? Is it possible that the banks reporting strong results now simply are better managed and avoided riskier plays? Yes, that’s possible, and maybe it’s true. But WorldCom was considered a well-managed company until it blew up. Think and research carefully before plunging into stocks of banks and other companies holding volatile assets.
Ironic News: a lock of Che's hair sells for $100,000. http://www.wtop.com/?nid=456&sid=1278591. The old revolutionary must be turning over in his grave at the thought that his hair might have been subjected to capitalism.
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