It is difficult to be bullish on the US financial sector these days. The sector hit another low this month and nothing that the authorities do or say seems to be making any difference. Despite this, buying high quality financial franchises such as Merrill Lynch will almost certainly prove to be a sound long-term investment.
There is no doubt that the asset class that is the most dislocated at the moment is credit. Spreads have ballooned in spite of low government bond yields and are now offering compelling value. Blackstone, which cleverly floated at the top of the private equity boom, said in a conference call last week that it expected to make several billion dollars of investments in these markets within the next 90 days. Banks, particularly investment banks, are most affected by this dislocation as they are forced to mark their assets to market, a process that in turn puts their balance sheets under strain. This leads to further widening of spreads and the vicious cycle continues.
The bears have argued that banks are in denial and have skeletons hiding in the cupboard. Unlike the early 1990s Japanese experience, which was driven by shame and the concealment of losses, however, the US situation is driven by guilt and the mantras of ‘full disclosure’ and ‘marks to market’, so much so that talk in Congress is now about modifying the mark-to-market rules. Last week, Standard and Poor’s (S&P) said that large institutions such as Merrill Lynch had “rigorously and conservatively valued their exposures and that most of the damage should be behind them”. Indeed it is quite possible that these institutions will be marking up their assets as credit markets stabilise.
The bears also argued that the monoline bond insurers would go bust and create a financial tsunami. Earlier this month the industry raised the necessary capital to have its AAA-status affirmed by S&P and Moody’s yet this has had no positive effect on the markets. The Federal Reserve has been accused of being behind the curve but recent actions and statements from the central bank suggest that it will do whatever it takes to get the credit market transmission mechanism working again – and it still has plenty of tricks up its sleeve.
The valuations of US financial stocks in mid-March were at distressed levels. Price to book was giving a strong buy signal, particularly on a relative basis. Mark-to-market rules also mean that book values are probably more conservatively valued today than in the 1990 recession.
In a nervous market, where the price setter is typically a trend follower with a short time horizon, the ‘short financials/long commodities’ trade, which has worked like a dream recently, may continue. But one day, investors will finally wake up, perhaps to the sound of the penny dropping.
Bull
Bear
