Sunday, March 15, 2009

Could It Be?

The following financial market commentary was written by Matt Malick and Ben Atwater. Matt and Ben recently started their own firm, Atwater Malick LLC. Matt was a student of mine and has a really insightful take on what's happening in the market. Ben and Matt have developed a sound and unique investment philosophy for their clients. They regularly write market commentaries and I plan to post them here for interested followers.
Could It Be?

As investors, we are constantly asking ourselves tough questions. Lately we have been grappling with the unthinkable.

Could it be that the major credit rating agencies will continue their abysmal predictive record?

Standard & Poor’s, Moody’s and Fitch are the three primary bond rating agencies and have enormous influence over Wall Street. The highest rating they bestow is Triple-A. As enablers of the great financial crisis that we are now facing, these agencies rated sub-prime mortgage-backed securities and collateralized debt obligations as Triple-A based on the ridiculous models that their firms created.

These firms once rated The American International Group (AIG) as a Triple-A credit, all the while AIG piled on mind-boggling obligations through credit default swaps (CDS), which last quarter led to the largest loss in American corporate history - $61.7 billion.

Without these colossal errors, our economy would be in a much better position. But, Standard & Poor’s, Moody’s and Fitch are not new to overlooking the elephant in the room. Remember Enron and WorldCom? Enron was rated an investment grade credit right up until the day it declared bankruptcy. WorldCom maintained its investment grade rating until three months before its bankruptcy.

Now these rating agencies are on a downgrading spree, cutting the ratings of vast amounts of mortgage-backed securities, many insurance companies and many banks. In fact, they recently downgraded the debt of both General Electric and Warren Buffet’s Berkshire Hathaway. If their track record holds, then they are likely to be wrong once again.

Could it be true that bears make money, bulls make money and pigs get slaughtered?

Wall Street banks, the rating agencies and the regulators all embraced the concept that thousands of bad mortgages bundled together as one security were transformed into a good security; after all, it was “diversified.” In an already overleveraged economy, faith in the all-encompassing power of broad diversification pushed us over the edge as the Wall Street banks leveraged their balance sheets thirty-to-one and bet the farm on these bogus mortgage-backed securities. Much of this was based on the misguided belief that housing prices could not decline.

Just as speculators participated on the way up to unsustainable heights, we now have others trying to push us down to new lows. The latest game in town is to drive fear about the prospects of certain companies by manipulating the credit default swap market. Credit default swaps are unregulated insurance that will theoretically pay if a company’s bonds default. The higher the premium on a credit default swap, the higher the implied risk that a company will fail. However, the market for these instruments is just small enough that unscrupulous players can create fear. Traders are shorting certain stocks (betting the stock’s price will fall) and then bidding up credit default swaps in an effort to fool the market into thinking that these companies are in irreparable trouble and then profiting handsomely from their short positions.

For example, according to a Merrill Lynch report issued on Friday, March 6th, the credit default swap market was indicating that Warren Buffett’s Berkshire Hathaway had a greater risk of default that the country of Vietnam and that General Electric was at greater risk of default than Russia (a country that actually did default on its debt in 1998).

If the track record of outrageous greed holds, then these scare tactics should ultimately fail. Just this week, many of the stocks that have been victims of this strategy have rebounded strongly. Let us hope that this is a sustainable stock market rally.

Could it be that individual investors are as wrong as ever?

The American Association of Individual Investors released its most recent survey of investor confidence. The survey is the most negative in its twenty-two year history, with 70% of the respondents bearish about the market’s prospects. The last time that 70% of the respondents agreed on something, it was in January of 2000, near the top of the technology stock bubble. At that time, 70% of respondents were bullish on the market’s prospects. Again, let’s hope their track record holds.

Could it be that there are two tiers of financial institutions, the awful and the OK?

The assumption before this week was that every financial institution was fatally flawed. Perhaps this is an overstatement. Of the Wall Street banks, we have thus far found that Bear Stearns, Lehman Brothers and Merrill Lynch were among the awful, but it appears that Morgan Stanley and certainly Goldman Sachs are among the OK. In terms of the super-banks, we know that Citigroup is awful, that Bank of America is perhaps somewhere between awful and OK, but it is increasingly appearing that perhaps Wells Fargo and J.P. Morgan are OK.

If our country truly has a large contingent of OK, i.e. well managed financial institutions, then there will be the opportunity for many positive surprises in the weeks and months ahead, much like we’ve seen this week.

Could it be that stocks are priced appropriately for a bear market bottom?

According to a recent Goldman Sachs study that analyzed the twelve previous bear markets beginning in 1929, assuming a March 2009 end to the present bear market, we are at very normal levels for a bottom. The historical average peak-to-trough price decline was 38%. We reached 56%. The average peak price-to-earnings ratio was 25.6. We reached 22.4 back in October of 2007. And finally, the historical average trough price-to-earnings ratio was 13.9. We reached 13.4.

Only time will tell, but there are numerous questions worth considering. The counter punch is that our economy and our markets are weakening at unprecedented rates with much of the rest of the world in even worse shape. Is this time different?

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