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Financials still have a ways further to drop
rayden
01-18-2008, 1:37 AM | Post #2477789
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My very simple thinking is something like this: right now financials are the sector with the largest total market cap, roughly 18% of the whole market, followed by healthcare, materials and energy at 12% each. At their absolute peak, in early 2007 they were just under 22%. In a nutshell, my target is for the financials to not be the largest sector anymore.
I looked at that - actually I looked at a huge Citi office building, went "hmm, that seems too big", and then I looked up the size of financial sector as a whole - and thought to myself "this can't be right" (TCBR) ... and any time I think TCBR I place a trade against whatever that is, so I started shorting the financials then, in a big way.
The reason why it doesn't make sense for financials to have the total market cap they have is because it just doesn't make sense for one quarter of the real value in an economy to be contained in an industry which basically moves around tokens that correspond to who owns what. Economically, financials are pure overhead. Sure, proper allocation of resources is important, but not more important than having those resources in the first place! A banker or insurer produces nothing that you can consume or use or that is of direct benefit to you, unlike the builder or doctor whose services you may obtain after dealing with the banker or insurer. Would you rather have an insurer and no doctor, or vice versa? Again, not to say that the service which financials provide, which is basically allocation, is not valuable, but there is no way that it is worth a quarter of the whole economy. (P.S. lots of other people, such as anyone engaged in business planning, also provide allcation services - financials just happens to be an industry of which that is the sole product. I would guess that in an efficient economy, allocation is the focus of maybe 10-20% of economic activity total, of which only a small part would be in banks, insurers, etc - maybe 5%? anything beyond that is unbalanced, and created by profoundly unnatural circumstances such as a short-term interest rate at 1.25%. no, I don't have any numbers to back that up, just a gut feel). Any time there is such a disconnect between what is real and the market, the market corrects eventually. "In the short term the market is a voting machine, but in the long term it is a weighing machine".
The reason why financials grew to the size they did is because "easy money" policies by the Fed benefit people in order of how close they are to the money, therefore the banks benefit the most, followed in second place by everyone who trades in stuff that is usually bought on credit (houses, cars, stocks - hence homebuilders, car makers, leveraged buyout firms), and everyone who sells to them in turn. While the "easy money" credit expansion party lasted, financials generated extreme returns, and the market rewarded them with a correspondingly high valuation, but now that is over... and we are in the credit contraction, defaults, asset destruction, and very limited new lending activity part of the cycle. This is when we discover that "prudent" banks are basically as overleveraged as drunken hedge funds in the style of LTCM, and a slight headwind is enough to wipe out all equity and reserves they have leaving them desperately looking for infusions of fresh cash.
I predict the sector to drop from 18% to around 8-12% of the total aggregate market capitalization, possibly first head toward the bottom of that range and then bounce up a couple of percent to the top of the range. That is a drop of 40-50% from current levels, relative to the whole market. I believe we will see a number of major banks such as C and BAC at ten year lows before this is over (others already are: WM). Look for XLF in the $16-18 range. Not to say that that would be _the_ ultimate bottom, just that I wouldn't even consider looking for a bottom before that occurs.
Another way to arrive at essentially the same prognosis is to pencil in some assumptions about the size of eventual housing price drops (20-30% nationwide, >50% in the biggest bubble markets - I think we will see a median house price to median income ratios of below 3 eventually), and then some corresponding assumptions about how much of that price drop will flow through into the balance sheets of banks and financials, versus their market cap.
Moreover, expect essentially no (or very low) dividends from financials for about a decade, as banks try to slowly rebuild reserves and absorb losses. Banks now issuing convertible notes at 7.5% to Abu Dhabi but continuing to make full dividend payments is another thing that "just can't be right", and probably won't last once they realize just how many writedowns and what reduction in earnings they're looking at longer term, and I don't mean next few quarters but rather decades.
I don't expect a lot of banks to outright fold, since politically nobody wants that, but expect to have a lot of "zombie" banks which are technically insolvent but continue to opperate with the cognizance of reguators, same as in Japan. Guess what, banks like that don't pay any dividends. Their book value is also a negative number. Of course, in the stock market, hope springs eternal, so they won't be valued literally at zero, but they'll be pretty close.
Since I formulated this thesis, the market has done a few things that I take to be a confirmation, such as the crash and burn in AHM, CFC, and spectacular drops in C, FRE, ABK ...
(Disclosure: short XLF WM DSL STI RDN ABK MBI and many more)
Topics
balance sheet
Credit Crunch
Credit Risk
Federal Reserve
Housing Bubble
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