Saturday, August 20, 2011

When the Cops Raid the Brothel, Everyone is Arrested -- Including the Piano Player

From the Desk of Joe Rollins

I’ve spent many hours over the last several days watching the stock market reports and the carnage taking place in the international equity markets. On Thursday – due to a rumor that was reported – the U.S. stock market also suffered a major decline. The rumor basically asserted that the European banks were suffering liquidity issues and had to borrow money from the EU in order to meet their current liquidity needs. In a market as jumpy as this one, all it takes is an unfounded rumor to create a massive sell-off.

I am amazed by the bargains currently available on the stock market. The only two asset classes that have increased in recent weeks are U.S. Treasury bonds and, of all things, the commodity gold. About two weeks ago, the S&P downgraded the U.S.’s credit rating, and ever since that day U.S. Treasury bonds have (counter-intuitively) rallied dramatically. At one point on Thursday afternoon, a 10-year Treasury bond was selling below 2%, a rate so low that it hasn’t been seen in the U.S. since just after WWII.

Additionally, gold continues to skyrocket beyond any reasonable level. No one has been able to give any economic explanation for the rally in gold; it’s so overdone at this point that it’s almost laughable. It’s hard to laugh, however, when U.S. Treasury bonds and gold are the only two financial assets to have increased while everything else has seemingly thrown the baby out with the bath water. Who is going to buy your gold when all other assets are worthless?

It’s fairly easy to see that those who are selling the market nowadays are doing so indiscriminately. It makes no difference whether you have a high performing stock like Apple or a low performing stock like Hewlett-Packard – they’re all being sold. It also makes no difference whether a country is financially strong like Germany or if it is a weak, essentially bankrupt country like Greece – they’ve all suffered the same selling pressures. The point I’m trying to make is that it would be an unusual time, indeed, if every financial asset other than Treasury bonds and gold were essentially worthless. I’ve never believed that before and I don’t believe it today.

I couldn’t help but look into the valuations of two of the major bank stocks – CitiBank and Bank of America. CitiBank has an international franchise and $273 of cash for every share of its stock. Cash today on CitiBank’s balance sheet is approximately $800 billion. The book value per share of its common stock is $60.33. However, today it’s selling for $27.84/share – less than 50% of its book value.

Bank of America’s valuation is even more pronounced. It has $63 per share of cash on its balance sheet equaling $640 billion. Its book value is $20/share, and it’s selling at $7/share – a mere 35% of its book value.

It should be fairly clear to anyone who even attempts to understand the value of these bank stocks that they are ridiculously low. There’s no question that banks face potential liabilities, but it’s unreasonable to believe that 35% to 50% of their net worth will be wiped out in unaccrued liabilities.

This week’s sell-off occurred when it was decided that the EU couldn’t possibly fund its debts. Clearly, in the eyes of many, the entire region was falling into a recession. While it’s true that Germany’s Q2 GDP was only marginally positive, it would be a mistake to dismiss that country as being financially weak. It’s one of the greatest engineering exporters in the world. Even if other countries in the EU fall into a severe recession, Germany will likely avoid it. If that’s the case, however, then why did Germany’s stock market index fall 10% this week?

The major market movers are again forecasting a severe and prolonged recession in the United States, but with very few facts to support their forecast. While it’s true that GDP has been low, very few economists are actually projecting a recession in the second half of this year. In fact, earnings projections for the largest companies have remained stable. It’s certainly not a guarantee that earnings wouldn’t be diminished if the U.S. fell into a recession. Since most of the Fortune 500 companies sell almost 50% of their products overseas, a recession in the United States wouldn’t necessarily impact valuations.

It was announced this morning that many of the major money market accounts are having a hard time showing a positive rate of return. Interest rates are so low right now that sponsors of money market accounts can’t even cover their own operating costs. A 10-year Treasury bond is selling at 2.1% today despite the fact that nearly everyone believes the rate of inflation will be greater than 2% over the next decade. Isn’t it interesting that people are willing to invest in money markets earning zero and 10-year Treasury bonds with a negative real return over inflation rather than a stock like AT&T with a fairly secure dividend yield of 6.1%?

My point is that reason has been abandoned because of fear. There’s a fear sweeping the world that is unsupported by the economic facts. After my most recent post, a client pointed out that I was perhaps missing a major component of stock market valuation – investor sentiment. While investor sentiment is undoubtedly impacted by Washington’s incompetence and the lack of leadership out of the Executive Branch, I still think our current issues have more to do with fear than with reality (although I’m not so sure I understand the root of that fear).

Today, it’s perfectly possible to buy a large number of utility and other stocks with dividend yields in excess of 5%. You can also very easily buy high-yield bonds yielding 8% or greater from very strong financial companies. Valuations on U.S. stocks are at multi-year lows and there are essentially no better alternatives for investing. Despite those positives, the market consistently goes through waves of fear. When investors are fearful, they do not sell based upon reason.

It’s also possible that – due to the extraordinarily negative investor confidence and the reductions suffered by the stock market over the last few months – the consumer could completely shut down. However, I really doubt that will happen. Retail sales for the last three months have been up consistently higher and car sales have been okay over the last six months, but will likely accelerate moving towards the end of the year. In the U.S., we are junking far more cars than we are selling new ones to replace them. With interest rates as low as they are, 30-year mortgages are now bordering on 4%. If you have contemplating refinancing your mortgage, now is the time to do so.

I turned off the financial news for a while to evaluate the facts and see if I was missing something in this market sell-off. It’s true that the cost of oil has decreased almost $20/barrel in the last month or so. The price of gasoline is $1/gallon cheaper, which provides an enormous windfall for consumers. Corporate earnings – rather than being diminished – have actually increased. Corporate earnings for Q3 were significantly higher than they were in the 3rd quarter one year ago, and projections for next year are even higher. The cost of buying almost everything is significantly lower due to lower interest rates. While unemployment is high, it is now trending lower. While the economy is flat, it’s a long way from being negative. The number of known positive facts to the number of known negative facts appears to be significantly greater. I can’t evaluate rumors, suspicions or even scare tactics, but evaluating only the facts doesn’t leave me feeling all that bad.

Before arriving at the office this morning, my anxiety was high. I was feeling a need to reallocate our portfolios, but after reviewing how they are currently invested I came to the conclusion that there was nowhere better to go. Our portfolios are invested with the best money managers in the world – all of them didn’t just wake up stupid! Valuations are extremely cheap right now and I believe the market will rebound very soon. Hopefully, you will be patient enough to enjoy the upturn.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins