Tuesday, 4 September 2007

The trouble with Financials

I've been banging on about earnings and in particular the future lack of them in the financial sector. As mentioned many times before I believe we are either at or almost at the top of the current US earnings cycle. Either this quarter or next the financial sector will drag the rest of the market into negative earnings territory.

Apart from a few recent downgrades from Merrill Lynch and Lehman Brothers Wall Street is still upbeat about forward earnings. John Hussman of Hussman Funds reminds us that;

"there is there is literally zero correlation between year-over-year changes in earnings and year-over-year changes in stock prices (much less quarter-over-quarter changes)".
This week amongst other things Hussman talks about why financials don't represent bargains just yet despite the hit some have taken. Click on the link below for the full article. If you don't already I thoroughly recommend having a read of John Hussman's 'Weekly Market Comment'.

The problem with financials

We continue to carry a very low weight in financial stocks. Though the recent weakness in these stocks has prompted a great deal of interest in “bottom fishing,” my impression is that such efforts are based on the same untempered assumptions of high and growing earnings in this sector that existed months ago. P/E ratios ought to be well below historical norms when those P/Es are based on record earnings and record profit margins. In my view, existing valuations are based on untenable assumptions of permanently high profit margins in this sector, with optimistic growth assumptions as well.

In 2000, this was the essential problem with the technology sector. It was some time before Wall Street's expectations caught up with the reality that profit margins are cyclical and that early declines off of overvalued peaks do not constitute bargains. I expect that in the next year or two, we will observe at least one quarter, and more likely a full year, in which the entire profit of the U.S. banking sector is consumed by loan losses.

Consider, for example, the latest FDIC Banking Profile, which was published based on June 30, 2007 data (before the recent liquidity crisis emerged). In that report, the FDIC noted that the ratio of loan loss reserves to total loans remains at a 32 year low. As for the portion of those loans that are in trouble, the FDIC notes “for the fifth quarter in a row, reserves failed to keep pace with the increase in non-current loans.” The industry's “coverage ratio” of reserves to non-current loans fell to the lowest level since the third quarter of 2002, while non-current loans posted the largest quarterly increase since the fourth quarter of 1990. Recall that 1990 and 2002 were periods when recessions were already well underway. If we're already seeing these signs of credit stress at the peak of an economic expansion, the figures we observe in a recession are likely to be a lot worse.

James Grant put it this way – “Benjamin Graham and David L. Dodd, in the 1940 edition of their seminal volume ‘Security Analysis,' held that the acid test of a bond or a mortgage issuer is its ability to discharge its financial obligations ‘under conditions of depression rather than prosperity.' Today's mortgage market can't seem to weather prosperity.”

As of June 30, 2007, the net income of all FDIC insured banking institutions totaled $36.8 billion. At an annual rate, that represents about 2% of all loans outstanding. Meanwhile, net charge-offs for bad loans were already running at an annual rate of about 0.50% in June. That's in a strong economy, before the recent problems, and loan loss reserves didn't even budge from a 32-year low. Net charge offs could easily quadruple in a mild recession.

Importantly, the problems go far beyond sub-prime. In its June 30 report, the FDIC noted “all of the major loan categories posted both increased net charge offs and higher net charge off rates.” Overall, net charge-offs jumped by over 50% from year-ago levels, with a jump of over 60% for consumer loans and over 70% for industrial loans. These percentage jumps are so high because they are off of such a low base, which underscores the extent to which observed profits in the financial sector have been unhindered by loan losses in recent years. Charge-off rates have not soared as much for credit cards, but this is because the existing level of charge-offs is already high (representing over 3% of the total amount volume of credit card balances, year-to-date). In short, the problems are in all categories, and given the thin coverage of the banking system for such losses, rising charge-offs and loan loss reserves are likely to bite deeply into earnings.

For some financials, relatively high dividend yields are being touted as a measure of safety and quality for investors. The difficulty is that if earnings come under pressure, a greater share of earnings will be required to cover those dividends. Of course, the long-term return is equal to the dividend yield plus the long-term growth rate of dividends. Though I don't expect forced dividend reductions for major U.S. bank stocks, I do believe that the growth rates assumed by Wall Street here are overstated. And while a well-covered dividend can produce a lower “duration” and therefore a smaller sensitivity to broad market fluctuations, it does not in itself produce an undervalued stock.

Historically, strong buying points for financial stocks have generally occurred when the group has traded at about book value. Currently, the typical multiples are two and often three times that level. That isn't to imply that financials must retreat to those lower valuations in this instance, but it's important to recognize that many financials are only “cheap” based on comparisons with very recent norms, and on the assumption that the high profitability levels of recent years will be sustained indefinitely.

In any event, my impression is that the problems for financials are just beginning, and that the risk premiums demanded by investors are likely to rise. As investors have seen throughout market history, stocks having rich valuations, weakening fundamentals, and rising risk premiums typically don't constitute great bargains.