Another article on the state of the banks. This one is bullish, which is also my stance. This one is written by Tom Brown, who was, and as far as I know, still a Hedge Fund manager. The gist of the article refers to the psychological aspects of the markets, and their [markets] forward discounting mechanism.

Did you read the stories yesterday that reported Tuesday’s rally in the financials? The headline writers seem confounded:
Financial Times: “Banks rally in face of gloom”

Associated Press: “Investors question financial sector rebound”
Wall Street Journal: “Five Banks Post Losses — and Their Stocks Soar”
New York Times: “Bank Investors Expect Less as Losses Mount”
For its part, Reuters was completely undone, and tried to ignore the stocks’ moves altogether: “Wachovia, other banks post dismal results,” it simply said, with no mention until the sixth paragraph that “dismal results” or no, Wachovia’s stock price was zooming. The stock closed the day up nearly 30%; the S&P Financials overall rose by 8.4%.

I’m confused why everyone is so confused. Of course stock prices will rise well in advance of any material evidence of fundamental improvement. That’s the way the stock market works. If anyone thinks a bell will go off at the bottom to indicate all’s clear at last, he’s in the wrong business.

Which is why I’ve been amused over the past few weeks as wags have begun to come up with their what’s-got-to-happen-before-I-turn-bullish-on-the-financials lists. They are comical. As I mentioned here earlier this week, OpCo’s Meredith Whitney says she won’t turn positive until the banks can demonstrate they can “grow again,” which no one doubts won’t happen until, oh, 2010 or so. Thanks, Meredith. Helpful!

Similarly—to pick out a list at random that’s as representative as any—commenter “DSB” at Seeking Alpha, remarking on my article Tuesday, says he doesn’t expect the financials to bottom until the following events occur:
1) Defaulting debt returns to normalized levels
2) We have a ratings agencies overhaul, which will allow IB’s to trade paper as freely as before they lost trust.
3) Oil falls & remains below $130
4) We have clear indication that unemployment has stopped increasing, CPI is ‘contained’
5) We have 2 consecutive quarters without a large/mid sized bank encountering problems.
All very sensible. There’s just one problem. By the time DSB’s laundry list comes to pass—two straight clean quarters from the banks, an overhaul of the rating agencies—the stocks will have long since begun a tear.

In the real world, it’s not unheard-of for cycles to turn when no hopeful evidence is apparent to account for the price reversal. Or if there is any, it’s so subtle that, by definition, it’s overlooked by the vast majority of investors. “Defaulting debt returns to normalized levels” doesn’t fit the bill.

Even so, there’s been no shortage of signs lately that the worst of the credit crunch is past, or soon will be. As we’ve talked about here for awhile, new delinquencies among the loans that make up the ABX subprime mortgage index have been declining for months, while delinquency roll rates have been improving. Lower delinquencies now mean fewer defaults down the road. Bingo! End of problem in sight.

Similarly, in the article in yesterday’s Los Angeles Times trumpeting “Record home losses in California” came this nugget:

The latest figures contained one surprise: defaults — the first step toward foreclosure — rose by just 6.6% in the second quarter, down from a 39% spike the previous period.
DataQuick President John Walsh said the reason was not immediately clear. Foreclosures may be “nearing a plateau,” he said, but it could also mean that lenders are “swamped and can’t handle processing any paperwork.”

Sean O’Toole, founder of the data tracking firm ForeclosureRadar, thinks the leveling off may mean that defaults on subprime mortgages — loans made to poorly qualified buyers — are nearing a peak. [Emph. added]

Now, I’m perfectly willing to believe that defaults have stopped rising as a result of paperwork snafus. But I doubt it. Regardless, this is just the type of data point that, years down the road (after the stocks have zoomed and while Meredith Whitney is still waiting patiently for banks’ earnings growth to resume) people will look back on and say “Aha! That’s when we should have known.” And the news is certainly delivered the way this type of information arrives: tucked away in article that otherwise describes how awful everything is.

I have been struck these past two days that all the objections to my argument that the financial have bottom a) make no reference to the stocks’ valuation and b) repeat facts that have been widely known for months. (Some readers also basically say that c: it’s different this time.) That’s all interesting, but irrelevant. The fact is, signs have begun to emerge that incremental change on the credit front is happening, and is positive. No, the signs aren’t obvious. But that’s my point. They never are.

The first area that we should examine is this quote;

I’m confused why everyone is so confused. Of course stock prices will rise well in advance of any material evidence of fundamental improvement. That’s the way the stock market works. If anyone thinks a bell will go off at the bottom to indicate all’s clear at last, he’s in the wrong business.

Why do market prices rise? There are many reasons, let’s look at a few.

*Short covering
*Valuations
*Change in fundamentals
*News [that encompass fundamentals & valuations]
*Momentum
*Technicals
*Hedging
*Other

Thus, there are many reasons why a stock, or market may start to rise [or fall] If you are going to invest/trade in that stock, or market, you need to understand why you are participating, and on what basis. That is to say you need a thesis as to why that market is moving [in the case of banks, finding a bottom]

There seems to be the assumption that this is a or “the bottom” for financials, based on “fundamentals” but little or no evidence is presented to make that case. What we are presented with are other peoples criteria that they feel would signal an all clear on a fundamental basis, with some evidence from the CDS markets later in the article;

Which is why I’ve been amused over the past few weeks as wags have begun to come up with their what’s-got-to-happen-before- I-turn-bullish-on-the-financials lists. They are comical. As I mentioned here earlier this week, OpCo’s Meredith Whitney says she won’t turn positive until the banks can demonstrate they can “grow again,” which no one doubts won’t happen until, oh, 2010 or so. Thanks, Meredith. Helpful!

Similarly—to pick out a list at random that’s as representative as any—commenter “DSB” at Seeking Alpha, remarking on my article Tuesday, says he doesn’t expect the financials to bottom until the following events occur:
1) Defaulting debt returns to normalized levels
2) We have a ratings agencies overhaul, which will allow IB’s to trade paper as freely as before they lost trust.
3) Oil falls & remains below $130
4) We have clear indication that unemployment has stopped increasing, CPI is ‘contained’
5) We have 2 consecutive quarters without a large/mid sized bank encountering problems.

With a rebuttal of their criteria;

All very sensible. There’s just one problem. By the time DSB’s laundry list comes to pass—two straight clean quarters from the banks, an overhaul of the rating agencies—the stocks will have long since begun a tear.

In the real world, it’s not unheard-of for cycles to turn when no hopeful evidence is apparent to account for the price reversal. Or if there is any, it’s so subtle that, by definition, it’s overlooked by the vast majority of investors. “Defaulting debt returns to normalized levels” doesn’t fit the bill.

Herein lies the connundrum. The author is correct, by the time many of these criteria come to pass, the banks may well have appreciated well above their lows. The psychological difficulty then becomes how to buy in the face of overwhelming pessimism?

Here the trading world breaks cleanly into two camps. We have the “pricing model” and the “timing model” If the timing model is used, technical analysis for example, the lows may represent your risk, exiting the position should that level be violated, simple in theory, less so in practice for many.

The pricing model requires an understanding of the banks financial statements. Banks as previously mentioned are notoriously difficult to analyse. As the author is [or was a banking specialist] why are clearer analytical methods not elucidated?

Even so, there’s been no shortage of signs lately that the worst of the credit crunch is past, or soon will be. As we’ve talked about here for awhile, new delinquencies among the loans that make up the ABX subprime mortgage index have been declining for months, while delinquency roll rates have been improving. Lower delinquencies now mean fewer defaults down the road. Bingo! End of problem in sight.

Credit crunch. An assumption that everyone is on the same page with regards to what constitutes the credit crunch can certainly serve to muddy the waters.

First, why is there a credit crunch in the first place? The credit crunch is not the pathology, merely a symptom of the underlying pathology. The pathology are the rising defaults within the poor lending standards that dominated since late or mid 2004, the sub-prime loans [liar loans] or no-doc loans, the Alt-A loans etc. The way that these loans were stuctured for securitization as MBS and selling into secondary markets etc.

These problems then caused massive losses as default rates started to rise in Junk Bonds that had through complicity in the Ratings Agencies [S&P, Moody's & Fitch] been assigned AAA ratings. When they started to perform like Junk bonds, holders reacted in a predictable manner, closing down the money wholesale markets and secondary markets for MBS, refusing to buy, and in many cases due to regulation, being forced to sell into an illiquid and falling market. This created massive losses very quickly, which drove banks via their holdings in SIV’s and mark-to-market accounting conventions to take massive writedowns, necessitating the requirement to raise fresh capital, while fighting technical insolvency, necessitating a bailout from the Federal Reserve in the form of lending against lower quality assets, viz MBS.

Add to that the tremendous levels of leverage employed throughout the financial sector, and it becomes clear how the losses increased exponentially. CDS contracts in nominal terms were approaching $60 Trillion dollars, with no regulated or exchange traded markets, pricing was opaque to say the least. With Bear Stearns evaporating almost overnight, reluctance to call a bottom is understandable.

If the conditions have changed [and they have] then, provide the data and evidence to support the assertation, if it is compelling, it will be difficult for the bears to refute logically with data and evidence.

The author then addresses this topic;

Similarly, in the article in yesterday’s Los Angeles Times trumpeting “Record home losses in California” came this nugget:

The latest figures contained one surprise: defaults — the first step toward foreclosure — rose by just 6.6% in the second quarter, down from a 39% spike the previous period.

DataQuick President John Walsh said the reason was not immediately clear. Foreclosures may be “nearing a plateau,” he said, but it could also mean that lenders are “swamped and can’t handle processing any paperwork.”

Sean O’Toole, founder of the data tracking firm ForeclosureRadar, thinks the leveling off may mean that defaults on subprime mortgages — loans made to poorly qualified buyers — are nearing a peak. [Emph. added]

The evidence he offers, comes from a newspaper, who have researched via the original data. Of course, why was not the original source quoted and researched by the author? No matter, but certainly does not inspire confidence.

Now, I’m perfectly willing to believe that defaults have stopped rising as a result of paperwork snafus. But I doubt it. Regardless, this is just the type of data point that, years down the road (after the stocks have zoomed and while Meredith Whitney is still waiting patiently for banks’ earnings growth to resume) people will look back on and say “Aha! That’s when we should have known.” And the news is certainly delivered the way this type of information arrives: tucked away in article that otherwise describes how awful everything is.

After presenting the aforementioned evidence, the author almost dismisses it as erroneous. Historically, is the only way to judge it’s accuracy is now propagated.

I have been struck these past two days that all the objections to my argument that the financial have bottom a) make no reference to the stocks’ valuation and b) repeat facts that have been widely known for months. (Some readers also basically say that c: it’s different this time.) That’s all interesting, but irrelevant. The fact is, signs have begun to emerge that incremental change on the credit front is happening, and is positive. No, the signs aren’t obvious. But that’s my point. They never are.

Apart from the CDS spreads tightening, what are the signs? There are signs, and plenty of them, but the author alludes to none of them. Is it any wonder then that he is having a harder time than normal in selling to the investing public a bottom in financials. Of course, selected financials would be a more prudent sell, as there are banks and financial institutions that may never recover fully.