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Buffett Buying Banks, but Don't Expect a Bottom Yet


We are in a similar economic and trading environment to the 1934-1937 bear market rally, and there's no telling how far markets will slide this time.

"The dogmas of the quiet past are inadequate to the stormy present. The occasion is piled high with difficulty, and we must rise with the occasion. As our case is new, so we must think anew, and act anew. We must disenthrall ourselves, and then we shall save our country." - Abraham Lincoln, address to Congress, 1862

I found this quote to be fitting, as the recent downgrade of the US credit rating certainly presents a challenge to our global stature. The question de jure is: Will the current environment and aftershocks circulating around the downgrade be a capitulatory event to equity market selling, or is this potentially the beginning to something much bigger? The dividend yield on the S&P 500 now sports a higher yield than the 10-year treasury, suggesting the herd will accelerate their move out of bonds and into stocks.

Further adding to a potential capitulation bottom, during the week ending August 10, investors removed $30 billion from stock funds that invest in US equities, the most since May 2010, when investors pulled money following a one-day market crash that briefly erased $862 billion. From a global equity perspective, it was the highest yank since October 2008, and the argument that this was a move that shook out loose hands is certainly relevant. The trailing P/E multiple on the S&P 500 is 12.9x, 3.5% less than the average multiple during the 10 contractions since 1949. Borrowed money in accounts at 61 New York Stock Exchange firms has fallen 4.6 percent, the biggest drop since June 2010, according to a July 22 statement from New York-based NYSE Euronext. Leverage slipped to the lowest level of 2011, according to Morgan Stanley's prime brokerage.

Accommodative monetary policies have done little to support a deflationary environment. The Federal Reserve has chosen to print "our" way out of this and has tabled the attention on inflation for another day. Ben Bernanke expects inflation to remain at 2% or below, a key component to further exceptional easing. Except that day may be sooner than the Fed intends. Deflation remains the more worrisome risk and likely downside leader, but recent inflation (August PPI and CPI) data came in rather hot. Low rates into 2013 will support dollar devaluation, a not-so-blatant way to cheaply finance our debt.

Using historical GDP data as a reference point; when annualized GDP growth falls below 2%, the economy steers towards a recession. Current 2011 GDP stands at 1.6%, following accommodative polices and monetary easing. Taking a look at the most recent ISM number, we are walking on a tightrope of contraction. Eurozone GDP growth fell more than expected to 0.2% on a quarterly basis from 0.8% in Q1 - the slowest since the end of the recession in 2009. Of particular concern is that the German economy almost stalled at 0.1%, down from 1.3% in Q1. Further on the topic of stalling second-quarter GDP, France reported an eye-popping zero Q2 GDP growth. This past week the Brazilian central bank lowered interest rates by a quarter percent; this is after it had already raised rates five times this year to combat rising inflation. Why the sudden change of mind? Central bankers fear slowing global growth, citing deterioration in the outlook for the global economy.

Up next to change course will most likely be the European Central Bank. It has raised rates twice this year but, according to Bloomberg, growth in the 17-nation eurozone slowed to 0.2% in the second quarter from 0.8% in the first quarter. The footnote to this data point, here at home, is that although we are walking alongside an economic-data-driven cliff, corporate balance sheets are in pristine condition. It will most likely require a swan-type event to tip the scale.

From economist John Mauldin:

Highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked. There are no good endings once you start down a deleveraging path. Much of the entire developed world is now faced with choosing from among several bad choices, some being worse than others.

Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang -- confidence collapses, lenders disappear, and a crisis hits.

On the surface, the four largest banks in the US -- Wells Fargo (WFC) Citigroup (C), Bank of America (BAC), and JP Morgan (JPM) -- appear to be in healthy shape with $471 billion of tangible common equity among them, nearly double their total in June 2007. Deutsche Bank CEO Joseph Ackermann said over the weekend, "All this reminds one of the fall of 2008, even though the European banking sector is significantly better capitalized and less dependent on short-term liquidity." Germany's DAX index responded with a 5% decline, while yields on two- and 10-year bonds dropped to record lows. Yields will continue to be depressed as confidence in the real economy and financial sector shift.
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