Bear Rally Refuses To Die But Don’t Get Carried Away

In case it is not glaringly obvious to you, the bear rally is still alive. Fundamentals have taken a back seat as investors continue to buy into the recovery story.

The rationale goes like this – the stock market is a barometer for the future and investors buy stocks based on future earnings power. If there are indications the economy is about to turn the corner, it is wise to invest heavily six to nine months in advance.

For those sitting on the sidelines, the temptation is overpowering. On one hand, they have significant funds to deploy and are itching to get their hands on long-awaited profits (or at least to cover losses from 2008) but at the same time, grossly worried that the uptrend is about to reverse in a drastic manner.

Actually, throwing money back into the stock market and engaging in some momentum trading is fine provided there is an exit strategy. You have to check your greed, sell into the rally and apply stop-loss orders.

Bank of America reported first quarter results that eclipsed its achievements in the whole of 2008. Its champange performance was promptly offset by news that it was adding $6.4 billion to reserves for bad loans.

In view of the larger provision, investors should exercise greater caution going forward. Nevertheless, the bear rally refuses to die. For that, we have to salute Wall Street for engineering such a robust stock rally. Do not forget though, that in the same manner this logic-defying rally is created, the liquidity can exit in a flash if the big boys pull the stop.

Over the past weeks, financials have led the charge on Dow Jones and S&P 500 but in all honesty, toxic asets are still lurking in the dark corners and we have yet to experience the worst of bank losses. Right now, the bank sector is propped by some loose interpretation of accounting rules, government intervention, undisclosed banks stress test results, a possible return of uptick rule and calling back of shorts in brokerage accounts.

Toxic assets are set to get even more skunky if housing prices nosedive and more foreclosures ensue. There is little chance of the banks getting their house in order (excuse the pun) without stabilising the housing market. Whether you like it or not, home prices and mortgages are closely interwoven with the fate of financial institutions and US economy.

And to dampen the bear rally further, we have the “authoritative” bank analyst Meredith Whitney offering a discomfiting forecast of home prices falling another 30%. That will surely spell crippling losses ahead for US banks and mortgage lenders. I will not be surprised if the battleground is littered with more carcasses of large to mid-sized US banks before we see the light of day.

Meredith Whitney opined that “home prices cannot bottom while liquidity is still contracting from the economy.” She predicts that peak-to-trough home price declines will average 50% nationally before the US housing crisis ends.

Whitney also believes that banks have not properly reserved against greater than expected losses in home prices. Her earnings forecasts for 2009 and 2010 are almost across the board lower than consensus. So, we can infer safely that the loss provision on BofA books is mild and its first quarter profits is an aberration.

To be sure, subprime crisis is going to pale in comparison to the next avalanche of losses from “good” loans which constitutes a much bigger percentage of banks’ loan portfolios. Banks will be forced to set aside more cash and subsequently cut into earnings. Already, prime mortgages delinquent over 60 days more than doubled in 4Q2008 to 2.4%, when compared to the first quarter 2008.

Commercial real estate losses are also a big concern, to the tune of an estimated $250 billion. General Growth, the second-largest mall owner in America, is a high profile casualty (in fact, the biggest real-estate failure in U.S. history) but it won’t be the last. Credit card losses are also mounting and could hit new highs in 2009. Capital One Financial just reported a loss of $112 million in the first quarter from defaults on credit card loans. Nobody can say for certain the impact of a full blown credit crisis on the viability of banks.

There is a strong likelihood of many highly leveraged financial instruments going awry in the coming months. The key priority for banks now should be to build up their loss reserves, since they stand at the apex of losses when their borrowers lose credit worthiness and default. If the banks cannot remain as a going concern, they have to go into liquidation. There is no two ways about it.

I mean, any normal business will be forced to do that by their creditors. Banks have shown no compunction in inflicting pain on business owners but they have been applying a double standard to their own state of affairs.

Banks are currently under no pressure to sell off their good or toxic assets to raise capital because they have a sugar daddy in the US Treasury standing steadfastly behind them which will bend the rules, recapitalize them covertly, underwrite all of their losses and pass them on to taxpayers.

Flushing out the toxic assets in banks takes time (especially when the definition of “orderly manner” has not been articulated) and reflating a bubble to achieve this objective is extremely dangerous. For the time being, I will stay clear from this mess as some astute economists have chosen to call such a situation “getting worse more slowly.”

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1 Comment

Filed under Banking, Economy, Stocks

One Response to Bear Rally Refuses To Die But Don’t Get Carried Away

  1. Good advice. I actually increased by retirement contributions a few months ago and bought some stocks. Buying in now I would be wary of (not regular buying – like retirement contributions). The rally seems a bit overdone in my opinion. However, I think prices were too low earlier. Whether the overdone rally increased prices above fair value is difficult to judge (if you know, you can probably be rich so good for you). There are still substantial risks and the economy is far from on solid ground. Financial companies are still run by people that think they can pay hundreds of people millions of dollars a year. I don’t think they have any concern for the companies they run. I would not trust those people with my money now – or several years ago. I have not owned their companies (other than in index funds). At times that has left me out of big gains. But the people in charge of those companies seem much much much more concerned with their personal profits and paying off everyone they know than in building valuable companies. I just don’t believe they have changed at all, and will continue the exact same destructive behavior they have engaged in for at least the last 15 years.

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