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 recent run on Bank of America's stock was not originated from a liquidity event, but deterioration of faith in the bank's future. Warren Buffett's $5 billion capital investment shored up the bank from a further speculative run based on his belief the bank can meet its obligations. What it likely did not do is place a floor underneath the common equity. BAC's CDS spread tightened by 120 basis points on the day of the Buffett backing; we know the common equity rallied as well. Interestingly, Goldman Sachs (GS) witnessed a similar event on the announcement in 2008 of his investment. Its CDS tightened handsomely and the common equity rallied, but both went on to make new lows. Looking at Buffett's prior preferred investments, Goldman Sachs fell 67% in three months and General Electric (GE) fell 42% in two months after he infused them with his capital in 2008.
The red flag from "America's bank" came days afterward when it announced the sale of half its investment in China Construction Bank; raising between $8.5 and $9 billion. That is roughly $14 billion raised. According to Bloomberg, BAC has $75 trillion in off balance sheet commitments. Nonperforming loans are $27.5 billion, and nonperforming assets $30 billion. Assets to cover these loans are roughly $37 billion. Liability and further litigation, now that the US government has announced its intention to file suit against BAC, will be concentrated to fraudulently originated mortgages, mostly from Countrywide. If Bank of America has $50 billion or more in additional losses to write down and the litigation extends for several years, it will only consume a nominal amount of the pretax earnings over that time. Again, unless another credit event manifests, the bank will likely not go under. If we are to witness a trickle effect from Europe, as we currently are, then all bets are off.
Let's characterize the state of the current US economy from the lens of 2007. At the time unemployment was relatively low and the Fed had the flexibility to be proactive, with the federal funds rate at 5.25%. Similarities can be extracted from the 2002 recession. Furthermore, the KBW Bank Index (^BKX) to S&P ratio hit a new low in July; the two previous occasions this occurred was December 1999 and April 2007. We know that both markets peaked within four and six months respectively, setting the table for a significant crash in each market environment.
I have previously made the case that we are in a similar economic and trading environment to the 1934-1937 bear market rally. Bear markets do not last as long in duration as bull markets, but they cover the same amount of ground. It is during moments of panic and waning investor confidence that predicting financial stress and forecasting market reaction possess an inverse relationship.
The New York Times published a piece last month comparing our current economy and the 1937 recession, which reflected my previous written thoughts quite well. "Manufacturing output fell by 37 percent in 1937." Our output is at a twelve-month low. "Unemployment, which had been slowly declining, to 14 percent from 25 percent, surged to 19 percent." In 2010 unemployment peaked at 10.2% and dropped to 8.1%; it now stands at 9.2%. "Price declines led to deflation." The "good news" is that it was a quick dip, lasting until 1938. What this article fails to deliver on are the similarities in the moves the stock market made in 1937 and what the today's market is doing. The bear market rally lasted from 1934-1937, 35 months, and the market gained 106%. Sadly the market dropped 49% thereafter. Our current cycle is at month 31 and toward its highs exceeded a 100% return.
We may not witness a recession by textbook terms, or it may be swift and short-lived. But what the data does not shed light on is how far markets will slide and the damage to investor confidence that will be left behind. Both of these circumstances are event-driven, and although we are seeing flashing signals to warn us, we do not know what the catalyst will be to tip us over. The retail investor is not participating in this market, but high-frequency trading and momentum hedge funds are. They have the ability, as witnessed during the flash crash and in August of this year, to move markets much more rapidly than even the most experienced investor can forecast.
Follow the markets all day every day with a FREE 14 day trial to Buzz & Banter. Over 30 professional traders share their ideas in real-time. Learn more.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter