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Market Rally Obscures Deeper Problems

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Search for bottom mirrors tech bust.

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For nearly a year, professional and individual investors have been trying to catch the falling knife in financial stocks even though it sometimes resembles a guillotine. We buy these stocks uttering phrases like "the bad news is priced in," "exceptional value" or "the high dividend yield is paying us to wait."

Investors who have been patient over the last year and have resisted the temptation to wade into the water were probably forced in with last month's surge in the sector as hope became the prevailing sentiment. We know the market and stocks are a forward-looking mechanism, so the theory goes that when these stocks start their ascent they're telling us six months from now the fundamentals will be apparent.

Sometimes the market looks forward and sees a mirage and six months later investors find themselves drinking sand.

While recent Fed actions have taken Armageddon off the table for financials, it doesn't change the fact that the likely continued decline in housing prices eliminates whole divisions dedicated to servicing a mortgage market that will take many years to repair.

Many become wildly enthusiastic about companies that meet guidance or have a write down that is only $2 billion instead of $5 billion, and spirits rise despite the fact that while companies are hitting the numbers, earnings are down 50% year over year. I suppose performance is relative?

Richard Bove of Punk Ziegel feels that traditional banks will be the first to rebound and that their businesses will improve with each quarter. I would tend to agree but finding the diamonds buried in the coal has been difficult at best. JP Morgan (JPM) and Wells Fargo (WFC) this morning seem to have navigated the terrain better than most, posting positive earnings surprises.

For the brokers the situation is far more difficult as many lines of business will be in decline for years. With the industries' most profitable products perceived as toxic it will be a monumental task to replace the lost revenue. Add to the fact that brokers are being forced to take down their leverage and repair balance sheets earnings power is greatly diminished. All eyes will be focused on Merrill's (MER) earnings report tomorrow, hoping to get a glimpse of how John Thain intends to right the ship.

This myopic focus on trying to get the bottom takes our attention away from the industries and companies that are working. Contrarians come out of the woodwork calling for a top in every sector that is doing well, has pricing power and is outperforming the rest of the market. The strong stocks are always perceived to be a bubble and weak stocks have value.

Market trends tend to have staying power in both directions. How long have we been hearing that commodities and energy are at a top or that financials are at a bottom? The truth is that when there is a real turn in the earnings power of brokers there will be plenty of time to make money even if you aren't in at the bottom. The sector will probably be poised to outperform for years. Let's not make things worse by guessing.

In the last bear market we saw exactly the same type of action, except the troubled sector was technology. All along the way, as the NASDAQ retreated from 5000 to nearly 1000, there were vicious rallies in technology stocks, forcing money managers to maintain some exposure in a sector clearly in decline. When the real bottom came in 2002, no one cared. Investors weren't talking about tech anymore. If someone mentioned Cisco (CSCO) at 10 most would yawn.

I suspect it will be the same for financials. When the financial media stops asking guests if they think this is the bottom in financials, that will probably be the trigger for a sustained move higher. Like most bottoms, very few will notice.
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No positions in stocks mentioned.
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