My Thoughts on Financial Companies Part II

I did not put on those trades I was referring to in my previous post concerning my thoughts on financial companies and it is a good thing I did not considering the blood bath of financials the Monday and Wednesday. One of the trades would have been in CCRT. I could sell a naked Jan call with a strike price of 10, immediately buy the stock at market, and get a 34% IRR. (At the time CCRT was around 18 and that was assuming I could split the bid ask spread in the middle) At the time it looked very safe with the stock having to drop 50% before I was out of the money by January. I looked at it and looked at it and decided to pass and that 50% has almost happened in three days. A couple other trades I am still looking at so will not comment.

Jim Rogers echoed some comments I have thought the last couple of days. This credit thing is truly another bubble. After the big drop in August, some of the value guys I respect were some of the first to dip their toes in on various names. I am not saying they are wrong, but I think the industry may have been in a stealth bubble. In other words, it didn't look like a bubble because earnings was there to make valuations looks reasonable. Ahh, but these earnings were made on instruments that were no where near priced correctly. Essentially with the very low risk premium these financial firms needed to produce that many more widgets to generate income. Well this created a viscous cycle that is now unwinding.

So lets say this risk premium was really a bubble (in the fact that there was no risk premium), well the unwinding of it could really just be getting underway. As I have said, a bubble demands bubble outcomes. S&P 500 was down about 50%. NASDAQ down 80%. Homebuilders are now down about 70%. Financials are down, what, 25 to 30%? Looking at this, it seems like everything has been shrunk down to quicker reaction. The homebuilders started moving down Sept 2005 until Sept 2006. Then you had a five month rebound before crashing again. In financials you had the big move down in August into September before a very big move up and now we are crashing again. David Dreman and Bill Miller both have said bank stocks are interesting with David talking about the scare that comes along every 10 years for financials.

Maybe he is right but historically financials have been around 20% of the S&P. We moved up to 25%. Doesn't this have to correct and almost overswing before the all the clear is out? Also high yield bond spreads haven't even reached their ten year average (This was as of two weeks ago, maybe they have now) which tells me spreads in this area need to widen. From homebuilders, to building suppliers, to banks focusing on subprime, to Alt A companies, to investment banks to mortgage insurers this has spread from one to other in a classic way. It has been very predictable and when I shorted the next step I usually lost 20% on paper first before the market finally was like oh yeah the subprime guys will get hurt and oh yeah the Alt A guys will get hurt and oh yeah the mortgage insurance guys will get hurt. Duh. So isn't it a duh that credit defaults will move back towards normal, that corporate bond spreads need to widen, that this will cause further pain in various financials stocks, that the Fed will continue be forced to cut rates, and the dollar will continue to fall? Once again it seems like a classic pattern that no amount of intervention will prevent. At best it may postpone the inevitable a little longer. The trick of course is making money in all of this until the market realizes that this time is not different.

So back to financials. The market keeps wanting to say oh okay that is the worst of the bad news and it is behind us. Then the news gets worst and the stocks get beat to death and then the market says oh okay so we had a 10 billion write down and the worst is now behind us, we know it is now back to normal. For argument's sake let's say the worst news is behind us. Does that make these things a screaming buy???? I really think the answer is a no. If the losses stopped tomorrow we are not going back to "normal." The pace and the frenzy and the animal spirits, as Bill Gross calls them, are not coming back (at least in this space, watch out emerging markets). What that means is "normalized earnings" that Wall Street has stuck in their head for these guys will not be around for at least two to three years.

The blood running in the streets is a common phrase that is thrown around. http://www.marketwatch.com/news/story/mark-hulbert-citigroup-good-buy/story.aspx?guid=%7bA02F53C1-74DB-4A8A-A817-D250BC2619A1%7d&dist=bondheads write about buying Citigroup and being a contrarian investor almost challenging you to see if you are a man enough to walk the walk and start buying C. To be honest I have considered some various deep in the money calls with C and have passed. I am not convinced that blood is running in the streets. Oh sure Wall St. is acting like it is. They are howling and crying and bemoaning and begging in true Wall St. fashion, but is there true blood? Wall St. estimates on bonuses came out the last couple of days from two separate firms. One estimates it to be flat and another slightly down from last year. Um if anybody noticed last year was a record record year when it came to Wall St bonuses and your telling me blood is running in the streets is flat to slightly down bonuses? Have there been any major bankruptcies? New Century was the biggest but that was subprime related. The Wall St. crowd would like you to believe that the sky is falling (and it may indeed fall) but it hasn't yet.

The question is if we were in a bubble that was just masked by tons of volume of very low risk premium securities making valuations looks normal? If the answer is no and this is just really a 10 yr scare in financial stocks then you should be backing up the truck. If the answer is yes then I think the stocks in financials as a whole may be about (optimistically) halfway done moving down. The great thing about running a concentrated portfolio is I do not have to vote one way or the other. I can look elsewhere.