Every now and then my hometown team, the Seattle Mariners, and the shares of large companies behave similarly.
They both mount a stirring rebound to give observers a glimmer of hope that all is not lost. (The M’s actually have the third best batting average in the American League following the All-Star Break.) But then you look up and realize that the Mariners are still 30 games out of first place in the American League West due to their terrible pitching—and as for stocks, eight of the past 10 weeks have been losers, as is the full year, to the tune of -14%.
Strangely enough, the reason for trouble at both the M’s and the market is similar: Bad players, bad management and an excess of optimism at a time that demands realism.
I won’t bore you with a litany of all the crazy roster moves and trades the M’s made en route to the worst season in their entire benighted history. But as for the market, it all begins and ends with the banks.
The U.S. market, just like most of its peers in the West, is led by large financial services firms. And financial services firms make money largely by taking a spread on loans—borrowing cheaply and lending dear. To the extent that the credit problems that we have discussed in detail for months has constricted the banks’ ability to make loans, their profitability has been badly impaired. (See also: "Don’t Trust the Bank Bounce.")
This is a problem because there are basically only three reasons for us to invest in a company: (1) We think that its earnings will rise, (2) that its price/earnings multiple will swell and (3) that it will pay us a dividend.
If a company’s main business is in decline, earnings can’t rise compared to prior periods. If that situation is likely to continue, then its price/earnings multiple will contract. And if earnings are so poor that the company cannot pay a dividend, then you have the triple-whammy that continues to grind down the company total value. It’s pretty much that simple.
Despite the listless advance in the big indexes lately, almost everything important was going in the wrong direction for banks. A key one was the bond rating agencies’ downgrade of the preferred shares of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE), which will have the effect of squeezing their ability to buy money-making mortgages more than ever.
And without Fannie and Freddie in the market for securitized loans it’s more and more difficult for smaller banks to lend money for mortgages. That in turn puts a damper on home sales and home values, continuing the vicious cycle. (To learn more, check out: "Recession Creates a Vicious Cycle.")
It’s interesting to note that the preferred shares were slashed to just above junk status because rating agency Moody’s said it expects the government to bail them out to prevent "broader negative economic effects." Moody’s cut the mortgage titans’ financial strength grades down to D+ from B- because it believes their "financial flexibility to manage potential volatility in mortgage risk exposures is constricted."
This is important because Fannie and Freddie are the only two financial firms that the United States is basically obliged to back up. If those two can go under, what hope do the rest of them have?
The two outfits are doing everything they can now to avoid having to show all their books, as they would have to do in a government bailout. But they’re not getting much interest even from private equity firms who are accustomed to taking big risks.
Mark Patterson, chairman of Matlin Patterson Global Advisers LLC, a private-equity fund specializing in distressed debt, told the Wall Street Journal today that the amount of money Fannie and Freddie need to raise "just dwarfs any capital the private-equity community might have. Begging at private equity’s door is using a Band-Aid to address a massive wound that’s been festering unchecked for years and years."
The hope that Lehman Brothers (LEH) would find a better fate in a buyout from the Korean Development Bank was equally misplaced, I think. Shareholders are looking for a takeover, but it’s much more likely to be a "take-under" with a price below the current value. Lehman is now priced, at a $10 billion market cap, at essentially the value of its crown jewel, the Neuberger Berman asset management firm, plus real estate. The market is saying that is still too high, so my guess is that over the next few weeks it will fall until it reaches a level that gives a margin of safety to a buyer. My back-of-the-envelope calculation suggests that is around 40% to 80% lower—or $3 to $6.
In summary, it is great to see the market up a touch in spite of a lot of bad news, but nothing has really changed in a material way. And when the fall rolls around it looks to me like stocks are vulnerable to shocks of disappointment.
In Trader’s Advantage, we’re ready for these developments with some short-selling positions on financial stocks that are paired up with long positions in gold miners and energy producers. Come take a look.
Jon Markman is editor of Trader’s Advantage and a regular contributor to InvestorPlace.com. To get this type of actionable insight from Jon and other InvestorPlace Media experts go to www.InvestorPlace.com today!
