Financials: Bottoms Happen When Everyone's Convinced They Won't

by: Tom Brown August 10, 2008 | about stocks: XLF    
Tom Brown

Tom Brown

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It’s of course my view that the financial stocks have made a bottom; I even have a strong suspicion the very day it occurred: July 15. And as I’ve noted here before, essentially no one else on the planet seems to agree with me. That’s life.  

Rather, the bears insist on seeing some kind of fundamental improvement in the outlook for the sector before they’re willing to invest. So depending on whose checklist you’re reading, non-performing loans need to peak and start to decline. Or net chargeoffs need to begin to come down. Or loss provisions have to fall. Something good needs to be on the horizon.

Sorry, the stock market doesn’t work that way. Remember, the market is a discounting machine: it anticipates key events so early on the vast majority of investors don’t even think those events are possible. In the case of the financials now, that means stock prices will turn higher (and already have, I believe) when most investors believe that things are still getting worse. It happens every cycle. 

So there’s no use trying to concoct your own list of mental milestones. Instead, go back and look at what happened (and in what order) during the last major credit crackup, in 1990-91. If you do, you’ll see that the bears have things all backwards. By the time their wish lists happen, the stocks will be zooming.

Take a look at the chart below. It shows banking industry net chargeoffs and loan loss provisions for the years 1988 through 1993. If you’d bought the stocks back then according to the logic most analysts are using now, you’d have dipped your toe in the water maybe in late 1991, when chargeoffs and provisioning was peaking or, more likely, in early 1992, when it was clear they’d started to fall.

And how would you have done? Not too darn well. Look at the chart again, along with the chart of an index of large-bank stocks below it. As you see, by late 1991, the recovery in stocks was already nearly half over, and the stocks had more than doubled. By 1992, they’d tripled. Nice call!

 

Rather, the index bottomed in October 1990, when chargeoffs and provisioning were still going up. At the time, no one thought things would get better anytime soon, (they were right!) the same way no one seems to think things are going to get better any time soon now. 

As I say, I believe the financials have made their bottom. Valuations are compelling, and the companies’ earnings outlooks have at least begun to stabilize. In particular, in the quarter just past, the inflow of new problem loans began to fall, and the rate at which early-stage delinquencies rolled into later-stage buckets declines. That’s what the beginning of an improvement looks like. Investor anxiety, meanwhile, is at a peak.

Eventually, these small glimmers of improvement will lead to what the bears say they want to see: a decline in problem loans, say, or declining net chargeoffs. The problem is, by the time that happens, the stocks will already have soared. 

Last cycle, smart investors began buying at the first, tentative signs of improvement. That’s what smart investors should be doing now, too.

Tom Brown is head of Bankstocks.com

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This article has 19 comments:

  •  
    Aug 10 09:11 AM
    first of all you have surviorship bias in the index you are using. second its only for large banks and those credit metrics are for the industry (big small surviors and failures). third those are annual credit metrics you are looking at. did the credit metrics hit their peak intra year? fourth, what about the interest rate enviroment. If i recall correctly they were in '90 higher than now and falling through 91-93 and banks then had securities portfolios (especially the large surviovors of the index you used) filled with good old fashioned T-Bonds/Bills (ie not credit vulnerable private securities that the banks have now) that greatly benefited from the rate declines. Rates can't fall that much given where they are now. fifth, large banks and particularly the survivors had much higher loan loss reserves than the banks presently do so. sixth banks then were much les leveraged than they are now. all in all clearly a shallow analysis to support your book
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  •  
    Aug 10 09:49 AM
    Dang. How many articles are you going to write reminding us you strongly believe the bottom in financials is in? If true, I'll be the first to congratulate you, at least for identifying it, if not calling it prior to it happening. I know investments are an ego-driven business but I think we all get it...you're convinced July 15 was probably the bottom. Great. But contrary to what you wrote, you aren't the only one who thinks so. Barron's does (their second bottom call) among others; plus one or two who wrote articles that were posted on this blog. There's no question you're an intelligent guy and you may be right in your thinking. However, a lot of smart guys have been sucking pond water since last year, in part because they seem too cocksure of their position. When that happens, a disconnect between analysis and great stockpicking can occur. I think everyone agrees- and forgive the Yogi Berra-ism - that the unexpected happens when people least expect it. Witness the 40-50% jump in the major regional banks the last part of July. But many of the bears aren't just saying they want to see improving fundamentals before they invest. They are saying drawing parallels to the early 1990s, for example, is too easy and potentially unwise. I recall people comparing the '87 crash to the '29 crash, and many opted out of the market, some for good. Anyway, I'm not sure the financials have hit THE bottom last month, maybe they have. But seeing how the group rebounded so strongly after dropping 70%+ or so, is it really going out on a limb to say they have?
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  •  
    Aug 10 10:00 AM
    If the bottom is here, where are future earnings going to come from?

    - We are in the midst of a credit contraction, only people with excellent credit histories are getting loans.

    - Spending is slowing down dramatically. No credit = no spending. Restaurants and retail are struggling. We are being forced to live within our means, which gurantees a reduced standard of living. Where are the bank profits in that? Besides, Baby Boomers have been given a reality check, the home equity they were depending on to finance their retirements is being wiped out, in addition to their 401k balances. Boomer spending will shift from mass consumption to health care. The younger generation, myself, is broke with our own mortgages and student loans. So we won't be able to pick up the spending slack. Immigrants perhaps?

    Please tell me where future bank earnings will come from?
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  •  
    Aug 10 10:03 AM
    It is never wrong to play a bottom as if its the real bottom. The bottom in March went up 17% and I got out when it started down. The financials are now up about 50%. I guess most people dont like money --or is it just FEAR that keeps them out. As Tom says if you wait until its for sure, its topped and you will ride it down again.

    I will bet on Tom and if hes wrong I will sell and keep my profits. Im a winner either way. I think the shorties are finished.
    Reply | Link to Comment
  •  
    Aug 10 02:21 PM
    i like filet mignon's reasoning,add to the fact we are (hopefully) coming off of a war economy,i don't know if we are done with the correction
    Reply | Link to Comment
  •  
    Aug 10 03:13 PM
    Tom:

    If only you were a good money manager, one who makes money in bull markets, then preserves wealth during bear markets.

    Then we wouldnt have to be subjected to what has been almost twice weekly for 5 weeks now, a slew of articles trying to convince everyone that now is the time to buy.

    Then there are those of us, who even though we are simple people, with no MBA, no formal training in finance, who have managed to guide their self directed portfolios to 15 year annualized returns of 20%, and who currently are up about 5% for the year thus far VS all the crappy returns for the major averages.

    Dont worry Tom, I am sure with some luck, within 2 years or so, you will make all your clients money back, then you can start collecting your performance fees again. If not, you can always go on CNBC and collect some appearance fees to pass the time.
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  •  
    Aug 10 04:41 PM
    TB has it exactly right. At this stage of the game, people should be nibbling, instead of quibbling. But some never get it, no matter how many market cycles they see. If the nibble turns out to be a bit too early, then fine, retreat and wait for a better entry point. If the first nibble shows a significant gain, nibble further, etc. This isn't rocket science. It's not about never taking a loss, and only jumping in and out with both feet at precisely the right time to show everybody what a genius timer you are. It's about building (or dismantling when required) positions in the same direction that price movement occurs. Doing things this way will ensure you are long in bull markets and out of bear markets.
    Reply | Link to Comment
  •  
    Aug 10 06:52 PM
    Tom Brown was a bank analyst for Smith Barney in the era he mentions....early 1990's. I remember hearing him literally POUNDING THE TABLE over the squawk box one morning, suggesting buying Bank America -- a $4 per share. He was laughed at by nay sayers then as well. My clients weren't laughing years later. They're listening now.
    Reply | Link to Comment
  •  
    Aug 10 08:02 PM
    ya and he's the same guy who thought IMB was a steal in the 20's -hows that one doing fer ya?? or did you not follow Tom's sage advice then?
    Reply | Link to Comment
  •  
    Aug 11 07:36 AM
    And don't forget FMD. What a disaster. To be sure, TB usually does the kind of forensic analysis that most don't. But does he know when to respect the counter-argument to his position? In my view, he's too quick to mock others if they disagree with his own analysis. To be fair, he's often right from a factual standpoint. No question. But knowing a company well is different from being correct with the buy/hold/sell recommendation. He made what I believe were great points regarding FMD; yet, the stock dived from $40 to $3. So what did he miss? And is he missing something now? Time will tell.


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  •  
    Aug 11 08:34 AM
    Forgive the bears here Tom...they know not what they do. Excellent article and I agree. I've been watching the market and cycles and investing sine the 1970s on. I've seen this cycle in every market downturn and each sector. Very few believe they should be buying (at least starting to) and that's why pessism is so rampant and why stocks are such a bargain...they should be since the stock prices reflect that give-away mentality. Of course, some bad news is yet to come if it is time to buy, remember Oct 2002 in tech?
    Reply | Link to Comment
  •  
    Aug 11 12:40 PM
    Tom, the more I learn about you Tom, the more I am shocked at your audacity. You took BIG bets on subprime, and lost your ass. How could you NOT see this coming, and expect us to hold you credible? What are you down on the year, 30%?

    hf-implode.com/ailing/...

    www.businessweek.com/b...

    "I think we're really close, if not at the bottom, for the financial services industry," - Great call Tom, way back in November of 2007!
    www.reuters.com/articl...

    Way to read the tea leaves Tom:
    “ Mr. Brown, whose hedge fund had owned 5 percent of IndyMac late last year, described Mr. Perry as an “eternal optimist.”
    www.nytimes.com/2008/0...

    And my favorite: Your recommendation to buy FMD on 11/30/07 when it was at $30.01/share. It is now at $2.90/share.
    vinvesting.com/vic-nyc...

    Please explain yourself.


    Reply | Link to Comment
  •  
    Aug 11 12:52 PM
    You owned 5% of Indymac bank going into Sept of last year, using something like 20% of your funds ($86MM out of ?), ouch.

    www.reuters.com/articl...

    "IndyMac is in a stronger position now because so many of its competitors have left the business, said Tom Brown, a former top-ranked bank-stock analyst who now runs hedge fund Second Curve Capital LLC. The New York-based fund has raised its passive stake in IndyMac to 5 percent from 2 percent, representing a total of 3.7 million shares"
    Reply | Link to Comment
  •  
    Aug 11 04:05 PM
    Tom,

    Your thesis hinges upon the theory that the market is a "Discounting Machine". This writeup questions the validity of that theory:
    seekingalpha.com/artic...

    Next: www.marketwatch.com/ne...


    Reply | Link to Comment
  •  
    Aug 12 08:11 PM
    You must be right... Crammer said the market has bottomed, Kudlow says we have a "Goldilocks" economy and Maria Bartiromo always manages to interview bullish portfolio managers who's livelihoods depend on a healthy market. What more do need to convince you that all is well? CNBC is a piece of immoral garbage and a big part of the cancer of greed and consumption that corrupts the US to it's core. I love how they are trying to fuel the greed needed to pump the market by airing half a dozen programs glorifying excess and conspicuous consumption. What a pathetic society!
    Reply | Link to Comment
  •  
    Aug 12 08:31 PM
    TB' thesis seems to make sense. Rich Pzena seems to think the same way as does Bill Miller.

    I had no financials in my portfolio prior to mid last year.

    I started buying financials a bit early (Aug 2007) a bit early in hindsight, and kept on buying through the Jan, March and June lows. I am at present just breaking even. As long as the situation does not worsen I am happy to collect dividends for the next couple of years and wait till the crunch blows over. I am focusing on buying big Money managers, Canadian (CIBC, BMO) and UK banks (Lloyds, Barclays) and Insurance companies. I have also taken big positions in AIG, GE, LM etc. I don't think their earning power has been compromised and most issues have been discounted into the stock price. I have avoided imvestment banks except for small nibbles which have been mostly losers.
    Reply | Link to Comment
  •  
    Aug 19 08:11 AM
    @E Nuff Said: when bill miller thinks that way - you should think twice.
    miller has become the prime example for how not to invest, for how not to fall into each and every value trap several times and how to not to ignore risk

    Tom: your thesis would certainly play out, IF the worst was really behind most banks and IF there were not trillions in off-balance sheet vehicles and IF the us consumer wasn't as overstretched and as indebted as he is these days. Unfortunately, all these three IFs are there and they make the outlook for most banks pretty dire.
    Reply | Link to Comment
  •  
    Aug 19 09:20 PM
    I think the market disagrees with your thesis.
    Reply | Link to Comment
  •  
    Dec 03 12:20 PM
    Wow, ANOTHER bottom is in. Tom, you have a lot of cajones to come here month after month spewing this crap.
    Reply | Link to Comment
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