Financial Stocks are in Free Fall
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Even for someone like myself who has been generally negative on the equity markets, this weeks’ action has been downright frightening. The financial stocks have been collapsing. Citicorp has gone from almost 10 to below 7. Goldman Sachs has lost about 10 points. GE and Goldman Sachs are hitting new lows. Even the supposedly “safe” banks like Bank of America, Wells Fargo and JP Morgan Chase are being hit with very strong selloffs. The scary part is that the selling does not appear to abate at any point. Although experience tells me that all the banks can’t possibly go under, the trading action on them shows no real buying support at any level. In my position, I speak to many people on Wall Street. The average broker or financial advisor I speak to was paralyzed 1 month ago. Today, speaking to them is like speaking to a zombie. Their minds don’t seem to comprehend the prices on their computer screens. As I stated last week, although it seems like a sign of capitulation (when almost everyone is extremely negative), the rallies don’t last very long, and are met with further selling almost immediately. I have no idea where the bottom is.
In other news, the auto makers are continuing their pitch on Capital Hill to get emergency loans. They are claiming that if they don’t receive cash immediately, they are all facing a possible Chapter 7 bankruptcy, and millions will lose their jobs. The only funny (and tragic) part of the hearing for me is when despite the CEOs pleadings, they all admitted that they had flown to Washington on their private corporate jets. Unreal.
Remember Warren Buffet and his famous bets on GE and Goldman Sachs? Well, not only have these stocks declined precipitously since he made his investments (although he does own preferred shares not offered to the average investor) but apparently his company may have problems. The credit default swaps (CDS) on Berkshire (which has lost over 25% in stock value the last 30 days) have soared. These CDS indicate that the risk in his company has increased dramatically. These CDS, which were at around 100 basis points in September, are now around 415. At that level, they are indicating a credit rating that is only slightly above junk for Berkshire. What happened? Well, apparently Berkshire Hathaway has sold contracts to undisclosed buyers that will protect the buyers against stock declines. According to Bloomberg.com, Berkshire may be on the hook for as much as $37 billion starting in 2019. As the markets have declined, Berkshire has already been forced to write down $6.7 billion.
Finally, Howard Silverblatt from Standard and Poor’s reports that only 16 of the S & P 500 are up for the year, according to the NY Times Floyd Norris. He points out that about 200 stocks have lost at least half their value this year.
The Great Auto Bailout?
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The automobile industry is now in the news every day. The so called “Big Three” (GM, Chrysler and Ford) are all in financial difficulty. These stocks have lost most of their market value this year on the back on mounting losses. The industry is now claiming that if the government does not bail them out, they will all face chapter 7 bankruptcy, which will result in massive job losses and an economic disaster. Critics of this bailout claim that the American auto makers are paying over $70/hour in labor costs, compared to only $48/hour at Toyota. Thus, the critics claim that until the business model changes, all the bailout will do is postpone the inevitable, as they will continue to lose money.
My take is this: To a great extent, the automakers brought this problem on themselves. First of all, why did they agree to such an egregious labor contract? Second of all, according to Consumer Reports, American cars are very lowly rated compared to their Japanese counterparts. For example, in their ratings of sedans priced between $20-25,000, the first six highest rated are Japanese made. For sedans between $25-30,000, seven of the top eight are Japanese. In sedans between $30-45,000, Consumer Reports rate only one American car in the top ten. The funny thing about this is, when I was growing up in the 1960s and 1970s, Japanese cars were considered to be cheaply made and of poor quality. Today, most people feel just the opposite is true. While Japanese car manufacturers figured out how to deliver quality product at an affordable price, the Big Three got fat and lazy, and now they are paying the price. However, although I think some of what the automakers claim is probably an exaggeration, I would still try to structure a bailout under the condition that union concessions are part of the deal. Clearly, writing a blank check makes no sense if the business model no longer works. All that will happen under that scenario is that the auto makers will probably be facing the same problem somewhere down the road. Therefore, one must restructure these companies by copying the Japanese and making quality lower cost cars. Of course, changing their cost structure must be involved. Although the unions are quite vocal, the fact remains that auto union membership has dropped by over 2/3 since 1979 according to Investor’s Business Daily. Clearly, even most auto workers don’t feel that union membership is all that important. Why should the government feel any different?
In the equity markets, stocks continued their decline after the Thursday rally. For the month of November, the US stock markets have now fallen for 8 out of the 11 trading days. The Dow and NASDAQ closed today no far from their yearly lows. Although there is no question that being short has been the way to make money for most of 2008, I am now seeing signs of capitulation in the market. It is very hard to find anyone out there who is positive on the markets. Generally, that means we could be close to at least a temporary low. However, economic news continues to weigh negatively on the market. Layoffs continue to grow. Citicorp announced an amazing layoff of over 50,000 of their employees worldwide. Retail sales dropped dramatically in October. Until we see some positive news, I believe these rallies will continue to be short lived.
The Black Swan
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Nicholas Taleb, whom I spoke about in previous articles, has coined a term known as a “black swan”. Simply put, a black swan is a completely unforseen event that throws all previous trading strategies out of whack. In the book, “Mobs, Messiahs and Markets” by Bonner and Rajiva, they discuss the following scenario:
Most people are not prepared to take huge risks in order to get huge potential profits. However, they are willing to take the risk of losing a huge portion of their portfolio if they think there is a good chance of constant small returns. In other words, many investors are prepared to grind out small but steady returns consistently. Unfortunately, what that unforseen event occurs (the black swan), they get crushed. This is exactly what has happened to most investors this year.
Take a fictitious investor called Jen. Upon advice of her respected financial consultant, Jen takes her portfolio of $1,000,000 and diversifies into a mix of corporate/municipal bonds, mutual funds and equities. Over the past several years, Jen has gotten average returns of around 7%/year, rarely showing a loss. She’s not looking for “home runs”. She’s very content to get a single digit return on her money because she believes she has a very low risk of any significant loss. Until this year, she was right. Unfortunately, when she looks at her statement , she is down almost 40%. She has completely wiped out all her gains over the last several years. She is stunned. Her financial advisor has no idea what to tell her. He is as shocked as she is. The net result is, she never realized the potential risk in a severe recession. Those were things that only happened in the 1930’s. Surely, the government had taken steps to avoid this. Unfortunately, what happened to Jen has happened to most investors this year. The moral of this story is to take steps to protect your portfolio.
The market finally staged a big rally for the first time this month, with the averages closing up about 6.5%. That’s the good news. The bad news is, there have no sustained rallies since August. Therefore, I have no real confidence that this rally will continue for any length of time. The only I do have confidence in is that the extreme volatility will probably continue through at least the end of 2008.
