Financials To Resume Meltdown Momentarily

by: Jason Schwarz August 13, 2008 | about stocks: AXP / BAC / GS / JPM / LEH / MER / SKF / WB / WM / XLF    

Jason Schwarz

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On the 16th of July, Lone Peak Asset Management initiated a buy recommendation on the S&P 500 when it was at 1,214. Since then, the index has risen 7% to 1,305 and we have exited the trade. The mantra of this bear market is 'buy the dips and sell the rips'; buy and hold has been a losing strategy.

The recent rally was the result of an oversold technical condition, government action to strengthen Fannie Mae (FNM) and Freddie Mac (FRE), rules against naked short selling, better than expected earnings and a dramatic decline in oil prices. If there is one lesson to have learned from 2008, it's that good news flow does not last. The focus will return to financial weakness before we experience a seasonal fall rally. Over the remaining 15 days in August, tread carefully as the following issues resurface:

1. SEC protection against naked short selling ends now. Rumors from short sellers regarding WB, WM, LEH, GS, JPM, etc., will resume. XLF should drop back into the teens and lead the broad market lower. The SEC would like to make these changes permanent but it will be at least 2 weeks before they draft anything up. Since this protection was put in place, Bank of America (BAC) is up 81%, Lehman (LEH) is up 41%, and J.P. Morgan (JPM) is up 32%. What will happen during this interim period? A final assault on the banks.

2. Consumer credit card use began to fizzle in June and probably continued into July and August. Read up on the American Express (AXP) conference call for details. Accounts 30 days past due are up 60%, and 65% of banks have raised the standards to access credit. This could be the next and last shoe to drop in the credit crisis. 2007 began the subprime mortgage meltdown, 2008 has been marked by sinking valuations of prime mortgages, and the theme of 2009 might be credit card debt.

3. J.P. Morgan issued a statement saying that trading conditions have substantially deteriorated since June. This will effect those financial leaders who have yet to be clobbered, like Goldman Sachs (GS). Ken Heebner, an investor who reportedly trades similarly to Goldman, suffered his worst month managing the CGM Focus Fund in July as he, and probably Goldman as well, expected oil to continue up to $200 a barrel. The other dark side of institutional trading has been caused by Merrill Lynch's (MER) decision to sell their mortgage backed securities for 22 cents on the dollar to Lone Star. Now all financial firms face further write-downs on this lower than expected valuation.

4. Further write-downs means more capital raising which means shareholder dilution. It will be another year before real estate bottoms so any hope for eventual write-ups is far, far, away.

With the market now overbought, these negative financial issues present the rationale for a sell-off but it will only be for the short term. The recent market strength was a precursor to a much stronger rally later this fall. Long term, conditions have definitely improved. A stable dollar combined with declining oil will pave the way for foreign investment in US equities. This powerful money flow will provide a boost to fall seasonality that we predict will push the S&P 500 back above 1,400.

Disclosure: Short XLF

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This article has 21 comments:

  •  
    Aug 13 08:30 AM
    Until we change the lifeblood of our economy from oil, oil will dominate the economy. Amazingly a littel recognized fact is that the amount of oil available to be purchased (World Oil Exports) peaked in 2005 at 46.342 mbpd (http:// http//online.wsj.com/a...

    Since the deficit has grown to 3 times the deficit of the 1973 Oil Embargo. The consequences is unstable oil prices. By 2010 the rate of decline will likely be 8% per year.

    If we re-tool transportation and power generation, growing efficiency, we can make the corner. If we do not, energy growth is negative and will cause economic growth to be negative. seekingalpha.com/artic...
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  •  
    Aug 13 08:34 AM
    Nice work Jason. I'm constantly the voice of dissention and usually disagree with these articles as sensationalism. Not this time. Whether or not I agree with your conclusions is immaterial. You gave us just the facts, son, and not too much in the way of conjecture. I applaud your honesty, lack of emotion, and reporting acumen. Kudos to you. I hope I see and will seek many more articles from you.
    Reply | Link to Comment
  •  
    Aug 13 08:39 AM
    "...buy and hold has been a losing strategy."

    Has there EVER been a bear market where "buy and hold" wasn't a losing strategy? For that matter, is there ever a time when "buy and hold" isn't outperformed by any number of other strategies? The difficulty (some would say impossibility) is in selecting short-term strategies which, looking back over a longer term, have outperformed.

    "1. SEC protection against naked short selling ends now."

    And you don't think the recent decline in the financials is anticipatory of this rule change? Why do you think the effect isn't already priced in?

    Much of the rest I agree with, except one thing: the value of prime mortgages. The decline in prime, GSE-backed mortgages presents a huge opportunity for the well-capitalized, as the market has beaten down their values unnecessarily. Those who are able to keep large amounts of these assets on their books will be rewarded on the other side of this correction, as these assets will appreciate almost exactly as much as they have depreciated to date. The government has made clear that it will make good on FNM and FRE promises - where's the risk that has caused these assets to decline?
    Reply | Link to Comment
  •  
    Aug 13 08:55 AM
    In paragraph 1 you countered your own point with the short rule on rumors which will force another move by the SEC.I Still do not know what will come out of it down the road. 2.The consumer: I understand your point.However I feel that in august there is a need for them to spend for a number of reasons now that energy shows signs of retreating and that will help their mindset and that will get them out and into the stores.The bar is so low and we always under estimate the consumer and their need to spend on themselves and their children without including intangibles.It will slow but again the bar is about an 1/8 of an inch off the ground.3.This is a big one because as you know the reverse of this trade can make up the difference in a hurry with today's trading abilities.I think people like that will do just fine.I'll leave it there on that for now.The .22 move is to involved for me at this time to get into it,but it needed to be done @mer and not all are created equal.Others on the buy side have to be looking at this and knocking on some doors trying to get in at those prices.That is why nothing else has moved yet.Maybe more go maybe not after watching the problems in the eu .22 here is looking cheap if a small percentage pan out and the price declines level of soon.I think they do into the elections by the new year.4.I am close with you on number 4.just not that far out.My reasons are many.I"ll give a few.The rapid rise of foreclosure sales from the people that could not face reality combined with the same homebuilders and the hardest hit areas are clearing inventory very quickly now.The faster they go up the faster they move.Everyday more get dumped into and cleared where as before it was stagnation.That to me is a positive sign.The banks are taking the provisions ,recent run ups in some not included reflect it. If that countiues like this while the Gov has the tools availble.People will be able to come back in was stability in our political sytem sets in.Again,as you know the markets make the turn way ahead of it.Today's number just placed the bar even lower,which is good for an possible upside and a further downside in energy/costs....
    Reply | Link to Comment
  •  
    Aug 13 09:05 AM
    Buy and sell--buy and sell is always a losing strategy--bull or bear. The ordinary citizen cant make money with short term trading.

    The last paragragh from BS is right on. Those who buy real estate mortgages will be rich some day. Those who buy and sell short term will die bankrupt.
    Reply | Link to Comment
  •  
    Aug 13 09:13 AM
    Are you saying in point 1 that the banks are going down now only because of the short selling rule? It has nothing to do with the fact that these companies are in serious trouble and any one way collapse at any moment? It has nothing to do with billions of loans outstanding that might not be paid back in full? It has nothing to do with having to use what precious little money they have to buy back auction rate securities that they sold by deception?

    With at least another year of write offs and to the real estate bottom, a contention that I believe is off by one to two years, why would the market rally in two months? Because it is forward looking and effecient? Just like it was forward looking in Aug-Oct of 2007 when it ran to a new high in the face of the sub prime meltdown?
    Reply | Link to Comment
  •  
    Aug 13 09:13 AM
    Sorry, the link to WSJ article on the decline in World Oil Exports was clipped online.wsj.com/article...

    The data is gathered but not directly reported by EIA or IEA.
    www.eia.doe.gov/emeu/i...
    www.eia.doe.gov/emeu/i...
    Reply | Link to Comment
  •  
    Aug 13 09:26 AM
    I heard, over CNBC this morning (8/13/08), that naked short selling ends today. So, it is no longer a mere "rumor".The CNBC anchor then proceeded to comment, along with her guests, that price of financials are expected to decline as a result. So our poster's theme is essentially correct. Of course, we'll see how the market actually reacts to this event. I am unclear, however, whether the nakes shortsale rule ends at the opening or at the close of business today (8/13/08), though, thru inference, it is more likely the former.
    Reply | Link to Comment
  •  
    Aug 13 11:06 AM
    Jason, I enjoy reading your commentary, but wonder about this comment: "J.P. Morgan issued a statement saying that trading conditions have substantially deteriorated since June. This will effect those financial leaders who have yet to be clobbered, like Goldman Sachs (GS). Ken Heebner, an investor who reportedly trades similarly to Goldman, suffered his worst month managing the CGM Focus Fund in July as he, and probably Goldman as well, expected oil to continue up to $200 a barrel" I

    I've heard Hebner speak many times over the past year and never heard him say anything that would suggest he is or was a making any bets on the short term price of oil. He DOES believe oil will continue to dominate the world's list of needed energy resources and has made a big bet that Petrobras will be a big winner LONG TERM. That position in addition to one in Mosaic are what caused the major hit to his portfolio. From everything I've heard, Goldman's portfolio is MUCH, MUCH more balanced in terms of asset allocation and is not subject to the whims of the stock market. If anything, I'd guess Goldman's commodity trading is likely to be one of the reasons Hebner had a miserable month. I'd say they may well have been inversely correlated recently. Using Hebner's performance as a proxy for Goldman's is nuts in my opinion.
    Reply | Link to Comment
  •  
    Aug 13 01:51 PM
    it's worth pointing out that it has never been acceptable for non-market makers to sell naked short. It wasn't acceptable before mid July and it still won't be tomorrow and next week. The SEC said they were going to pay more attention to shorts and check more frequently to see if shares were in fact borrowed. This was the financial equivalent of "rounding up the usual suspects" when the markets are falling and you have to do something.

    Mr Schwarz has himself rounded up the "usual suspects" by telling us that this one month "ban" is ending (anyone with a calendar could have told you that), repeating information well known on the street (#2,3) and speculating (#4).

    The only information that matters in finance is information that surprises the market. None of these four points qualifies.
    Reply | Link to Comment
  •  
    Aug 13 04:08 PM
    Allowing the ban on Naked Short Selling to expire is simply throwing gasoline on the already flaming funeral pire of the financials...don't be surprised to see a couple of more "Bear Stearns" in the next two weeks.
    Reply | Link to Comment
  •  
    Aug 13 04:10 PM
    Allowing the the ban on Naked Short Selling to expire is simply throwing gasoline on the already flaming funeral pire of the financials...don't be surprised to see two more "Bear Stearns" in the next couple of weeks.
    Reply | Link to Comment
  •  
    Aug 14 03:49 PM
    Short CFFN. Why is this financial @ a 52 week high
    Reply | Link to Comment
  •  
    Aug 15 11:12 AM
    The financials are cooked.
    Reply | Link to Comment
  •  
    Aug 15 11:54 AM
    "we always under estimate the consumer and their need to spend on themselves and their children without including intangibles"

    Be that as it may, over 2 million households will have been foreclosed by this time in 2010. I see those as households whose financial and emotional crises will take them out of the consumer economy for a decade or more. Doesn't 2 million households sound like a lot to you? I can't imagine the consumers returning to their place as the engine of the economy any time soon. Especially when the credit card debtors discover what the real estate debtors have, that there's safety in numbers and defaulting with the crowd is a sound strategy for the overextended.

    As for short selling, indicting a couple of traders and brokerages should do the trick. Nothing like a good execution now and then to keep order on the street...
    Reply | Link to Comment
  •  
    Aug 15 03:41 PM
    Once again, this 22 cents bullsh#t is the biggest lie on the Street. They got a little over 5 cents and have financed the rest with a non-recourse loan. They HOPE to get 22 cents.
    Reply | Link to Comment
  •  
    Aug 15 10:00 PM
    OMG, two articles in a row by this guy. What did I do to deserve that.

    A piece of advice from an avocation I pursue: If you are a young man, grow a mustache. If you are old, lose weight.
    Reply | Link to Comment
  •  
    Aug 16 07:59 AM
    The likelihood that Goldman Sachs listened to its own claim that oil was going to $200 per barrel is zero. That was for public consumption. JP Morgan knew better also. The deteriorating trading conditions they announced at JP Morgan related to mortgage debt, not commodities trading. The primary dealers of the Fed, including JPM and GS, have manipulated this commodity crash into existence, and, certainly, were not caught off-guard.
    Reply | Link to Comment
  •  
    Aug 16 11:30 AM
    Now taht options expiration has ended many of these"propped up" financials which have been put to unsuspecting souls should lose value led by COF and BBT
    Reply | Link to Comment
  •  
    Aug 16 04:24 PM
    credit cards will not blow up for sure. Jason is very short-sighted. he has no clue how card companies make their money.

    seekingalpha.com/artic...
    Reply | Link to Comment
  •  
    Sep 08 08:25 AM
    Back to the Jay,How has this changed the game and to all of the people that were short in this case wm.After seeing the news flow over the weekend how does this change or does it change your opinion?I am long a baskes of them wm is one of these.You also had what appears to be be positive news out of wm as well.
    Reply | Link to Comment
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