Fundamental Trading Diary

Fundamental analysis of the capital markets

A Study of Market Recoveries

1948-2008

Fg. 1: Unemployment Rates, Non-farm Payroll Change m/m and the Dow: 1948-2008

The stock market is driven by the availability of capital coupled with stocks being the most attractive investment vehicle.  The American stock market has also benefited from foreign capital in-flows due to its having both the largest companies in the world and massive liquidity.  More recently, the procedes of foreign owned American consumer, corporate and government debt has also been re-invested through American investment banks.

The last source of capital availability is monetary inflation.  Monetary inflation, however, will not raise the real value of any kind of security – stocks, gold or bonds.  In many case, particularly bonds, this actually leads to wealth destruction.  Gold is also destructive of producticity:  the total value of gold takes production away from the economy in the cost to mine it, transport it, hold it and secure it.  It certainly has been a vessel to retain wealth, but this is not an investment strategy – it’s a wealth presevation and storage facility at best.

Unemployment rates peaking 4 months and 10% later in 1949

Fg. 2: Unemployment rates peaking 4 months and 10% later in 1949

A Story of Recovery

The most directional of economic data is likely the unemployment rate.  Figure 1 shows the unemployment rate on the bottom half in red.  The unemployment rate is erratic, highly directional, and an immediate (monthly) statistic exposing the contraction and expansion of the economy in very real human terms.  When the economy is contracting, it is very difficult for new business to grow.  A recovery in unemployment rates is almost always preceded by market action.

Unemployment rates peaking 6 months before the massive 1958/1959 bull market

Fg. 3: Unemployment rates peaking 6 months before the massive 1958/I 1959 bull market

It’s also important to note that the market dynamics weighs information differently depending on the context.

Conversely, the market tends to be overly optimistic at tops.

To address whether the valuations of US companies are attractive enough to invest in, we must look at the P/E ratio to see how expensive stocks are relative to their earnings.  What that number will be is currently up in the air:  we’ve just entered earnings season, and we’re going to find out how bad it really is out there.  This is combined with the October end-of-fiscal-year effect – we’re in for some more volatility to be sure.

Top-Down Analysis For The End of the Year

The top US banks are not overly leveraged — especially considering their European counterparts.  This fellow here has listed the top banks by assets governed in the USA and Europe and their leverage ratio.  I have no idea how the Europe is going to get out of their mess.  750B should be more than enough stablise the lending markets.  It wouldn’t even come close to allowing European banks to safely deleverage.  They’d better hope that train stays on track.

What it will do is help restore profitability in the financial sector – particularly in the Mortgage Investment, Investment Brokerage, Credit Services, and especially Regional Banks and Money Center Banks.

To put this in perspective, there are roughly $10.461 trillion dollars in consolidated assets held in major banks (assets governed of more than $300 million).  The top 5 banks hold half of that.

Up to date (Jun 30/08) debt/equity ratios:

JPMorgan Chase    –    9:1

Bank of America   –    9:1

Citibank               –    13:1

Wachovia             –    53:1

Wells Fargo          –    4:1

The plan of action is quite clear:  these big banks need to be kept profitable to maintain their shareholder equity and absorb the weaker banks with the help of the government.  Were these institutions to fail, The Great Depression would look like a cakewalk.  They make up for more than 5 trillion in deposits – roughly 1/3rd of the entire size of the US money supply.  Are we rewarding bad management?  No.  JPMorgan Chase, Bank of America, Citi and Wells Fargo are now put in the position of being able to save the rest of the lenders with their conservatism and some money supply inflation.  The key here is to do as much to stablise the credit markets and restore confidence as possible while having the print the least number of dollars.  Printing too many will result in a currency flight – but it won’t be to Euros (they’re going to have to print at a rate 3x ours), but probably rather hard assets.  Since hard assets (precious metals) are entirely productively useless, that would slow the economy down even more.

With profit margins on that 5 trillion managed only being around 34 billion, the 700B could be used to take the leverage ratio of the top 5 banks down to just over 5:1.  Over the course of a year, that would double their current profit, and the S&P 500 would gain roughly 20% from this action alone.  Hopefully this would grease the wheels and allow businesses to borrow and compete as usual.

I consequently think that the worst case 12-month return from this point is 20%.  I don’t think that this is a long-term solution in any stretch of the imagination – but it’s actually not our side of the Atlantic that’s really the problem when you compare our paltry 17:1 asset weighted average leverage to their 32:1.  The net result will be even larger EU sponsored packages which will allow their lower leverage banks to merge with more dangerously levered ones, and as a consequence, I suspect that the US economy is going to be quite a bit more competitive than the EU zone for the next 2-5 years.

Long a pair of ES contracts at 1143 and 1120 for the long haul.  I suspect the S&P 500 will particularly stand to benefit from the large exposure to large capitalised bank stocks which will see part of the “bail-out” go directly on their balance sheets.

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October 7, 2008 - Posted by | Uncategorized

2 Comments »

  1. The debt/equity ratio is as well a risk indicator as an indicator of confidence. British, Swiss and German banks enjoy a way higher confidence of their investors, than American banks, because the risk management follows the Bale II rules. That is not the case with American banks.
    What we see here is a collision of the American and European banking cultures, including the refinancing requirements.
    The invention of the toxic papers is clearly American (Sanford Weill); going into and out of the mess supposed to be lead by the Americans.
    I just doubt the effectiveness of the $700b bailout. The point here is the gray zone, in which the creation of surplus money supply happened. Just put that amount (about $2 trillion borrowed against nothing, if I remember right) into relation to real-world money – $700b.

    Comment by Georg | January 10, 2009 | Reply

    • Thanks for the response. Those are fair points. Some of the “collision of Euro and American banking culture” is also the more strict reporting and auditing requirements in the USA. Although it’s largely a joke, it’s still more stringent and reliable than in Canada or Europe.

      I think much of that difference is also in the politics — countries in the EU have simply been nationalising banks, while the USA has chiefly been trying to recapitalise them.

      The amount — $700B (probably 3x more than that by now if you consider the Fed balance sheet growth which is probably effectively as permanent – the operations might be classified as temporary, but they have simply been juggling a larger and larger repo market… I crunched the data and graphed it some time ago) — might be enough if you did the right things with it. I think a lot of alarmists are looking at the notional size of OTC markets in a vacuum. Somewhat similarly, every so often, someone looks at the futures exchange deliverable inventory against the open interest and cries fire. Reality is a lot more complicated, and stuff like commercials hedging their production make it a lot less scary. The problem is that we don’t know enough about these OTC markets due to lack of transparency, and the counter-party risk is probably very complicated.

      Comment by mbusigin | January 10, 2009 | Reply


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