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Distinguishing Between Out of Favor Sectors and Doomed Ones

by: David Merkel September 10, 2008 | about stocks: COP / GEHL / JNY / LEH / LNC / SCVL / SPY / XLF    
David Merkel

David Merkel

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It’s a tough market out there.  You can’t eat relative performance, and I am off a percent or two year-to-date.  I have made a number of moves in the portfolio recently:

  • Rebalancing sale of Jones Apparel (JNY)
  • Rebalancing sale of Shoe Carnival (SCVL)
  • Rebalancing sale of Lincoln National (LNC)
  • Rebalancing buy of ConocoPhillips (COP)
  • Sale of Gehl in entirety (GEHL).

In a bear market, I consider it unusual that I have gotten off so many rebalancing sales, but part of that is being willing to embrace an out-of-favor sector — retail.  That said, my cash position has risen to around 6%.

In this situation, being willing to embrace out-of-favor sectors, but not “doomed” sectors, can pay off.  In my opinion, depositary and credit-sensitive financials are a doomed sector until the backlog of questionable names begins to diminish.  Fannie (FNM) and Freddie (FRE) are off the table, and didn’t S&P do us a favor by kicking them out of their indexes?  Surely they will add them to the Small Cap 600, right?  Sorry, no.  The cow is out in the pasture; closing the barn door won’t help.

Part of the trouble here is ripple, or second-order, effects.  Ordinarily, second-order effects diminish and get swallowed up by larger factors affecting the economy/markets.  But with financials, because of all of the layers of debt, the failure of a large institution can lead to a cascade of failures.  Much as I don’t like government bailouts, the reason why the Treasury stood behind the senior obligations of Fannie and Freddie was to avoid a cascade of failures, because their senior debt and guaranteed MBS are so widely held by financial institutions.

Until the institutions that can produce ripple effects either fail or conclusively survive, the bear market continues.  Bear markets are most often financing - driven; so long as financial firms are under stress, firms that rely on them for financing will be under stress as well.

Bailout Conditions for Lehman Brothers (LEH)

On an unrelated note, what should be the terms for bailing out Lehman Brothers?

  • The government should only care about systemic risk, not specific risk, so they should only guarantee the derivatives counterparty of Lehman, with significant skin in the game from Lehman.
  • The equity, preferred equity, and subordinated debt of Lehman should be wiped out before the Treasury shells out one dollar.
  • Senior debtholders should take a haircut — they will get paid in new Lehman stock.

For the market to normalize, the big problems have to be resolved.  Lehman Brothers is one of those problems and it is not resolved yet.

Disclosure: Long LNC SCVL JNY COP

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This article has 13 comments:

  •  
    Sep 10 01:11 PM
    Exactly. Others here have called this right, government has rewarded criminal activity, malinvestment and underperformace. Now the global investor and US domestic investor has little confidence in the entire economic system. The entire bill for this criminal housing and i-bank sector are being dumped right onto the lap of the Middle Class. The Middle Class is already near a breaking point and I expect much civil unrest in the next few short years. It is Washington that must be radically changed and for that, pain is the catalyst that creates necessity. Necessity is the mother of all invention.
    Reply
  •  
    Sep 10 01:25 PM
    "The cow is out in the pasture; closing the barn door won’t help." Sorry but you have the quote wrong. It's "After the horse has left the barn . . . " etc. Is it possible you have other "quotes" wrong as well? Not all of us are as wise as Solomon.
    Reply
  •  
    Sep 10 01:28 PM
    PS: Are you one of those big hedge funds that screw everything up? I hope not. Just think, I might have invested with you.
    Reply
  •  
    Sep 10 01:41 PM
    The author is right regarding one point on Lehman - the equity and sub debt must go first. But we should not be doing bailouts. He is wrong on why Fannie and Freddie needed to be bailed - he says that was to avoid a cascade effect? How is sending the stock to zero avoiding a cascade? It's protecting special interests, is what it is.
    Reply
  •  
    Sep 10 02:38 PM
    "How is sending the stock to zero avoiding a cascade?"

    I can't believe this needs to be explained to anyone sane enough to operate a web browser.

    Fannie and Freddie had *debts* into the trillions, all of it owned by other institutions, since no one owns their own debts. The whole issue is whether all those who *lent* to them, would be dragged down with them as well. By protecting the creditors and sending the stockholders to the wall, regulators avoid a cascade of additional failures from the failure of Fannie and Freddie - and my sending the stockholders to the wall, they maintain incentives to avoid failed investment.

    The prior comments on Lehman are equally uninformed, while the article takes a sensible position.
    Do all those screaming for destruction as more moral think we are talking about Lehman? We are talking about anyone who ever traded with Lehman, which includes oh about half the financial world.

    The costs are already going to be born by everybody, because they are too large to be born by a few narrow institutions or people. No amount of whining about it will reduce the losses one iota, or keep any of it from ever mattering to you. "But its unfair that other people's mistakes hurt me!" Tough toenails. If everyone dropped dead tomorrow it'd effect you too. Everything does. It is called existence, grow up and deal with it already, and stop the bleeping whining.
    Reply
  •  
    Sep 10 02:52 PM
    Or stop the wrangling. It won't get you any closer to Valhalla.
    Reply
  •  
    Sep 10 03:47 PM
    The costs need not be borne by everybody. They need to be borne by many, though - the mismanaged lenders, as well as buyers who paid inflated prices. It's simply not going to work to prop up home pricing by backing bad loans. You seem to be forgetting that the conceptual solution to the problem of overpricing is apparently to prop up the prices rather than let them normalize...which is the only thing that will actually work.

    I'm going to leave you with one thought to ponder: that debt has market value based on the assets underlying it. Those values aren't going to change based on the government stepping in - they will only change based on demand for those assets. The private sector can get better value from those assets, based on free markets, than can the U.S. government, which does not know how to operate in those markets!


    On Sep 10 02:38 PM JasonC wrote:

    > "How is sending the stock to zero avoiding a cascade?"
    >
    > I can't believe this needs to be explained to anyone sane enough
    > to operate a web browser.
    >
    > Fannie and Freddie had *debts* into the trillions, all of it owned
    > by other institutions, since no one owns their own debts. The whole
    > issue is whether all those who *lent* to them, would be dragged down
    > with them as well. By protecting the creditors and sending the stockholders
    > to the wall, regulators avoid a cascade of additional failures from
    > the failure of Fannie and Freddie - and my sending the stockholders
    > to the wall, they maintain incentives to avoid failed investment.

    >
    >
    > The prior comments on Lehman are equally uninformed, while the article
    > takes a sensible position.
    > Do all those screaming for destruction as more moral think we are
    > talking about Lehman? We are talking about anyone who ever traded
    > with Lehman, which includes oh about half the financial world.

    >
    >
    > The costs are already going to be born by everybody, because they
    > are too large to be born by a few narrow institutions or people.
    > No amount of whining about it will reduce the losses one iota, or
    > keep any of it from ever mattering to you. "But its unfair that
    > other people's mistakes hurt me!" Tough toenails. If everyone dropped
    > dead tomorrow it'd effect you too. Everything does. It is called
    > existence, grow up and deal with it already, and stop the bleeping
    > whining.
    Reply
  •  
    Sep 10 03:58 PM
    Socialism cannot compete, dude you are an idiot. You think the market would be ok with 5 Trillion in debt being at Risk? The private markets aren't going to find a "better value" for that debt. They would mark it WAY down, even though most of it isn't at risk and will be paid off eventually. The market ALWAYS overreacts to the upside and the downside. Period. End of Story. The efficient markets theory was thrown out eons ago. Perhaps you had your business schooling in the 70s or something.
    Reply
  •  
    Sep 10 04:20 PM
    DM: On an unrelated note, what should be the terms for bailing out Lehman Brothers?

    What? Why do you assume a bailout is necessary?

    Lehman's counterparties are all "institutional investors". People with MBAs and PhDs. People who collect millions of dollars per year in compensation because they are supposedly so much smarter than everyone else.

    The argument to bail out Lehman (or WaMu or any other) is ridiculous. The consumer is roughly 70% of the economy -- that's more than ALL the banks put together. If XYZ bank is too big to fail, then the consumer is way way way too big to fail.

    So we should all send our mortgages and credit card bills to Paulson. And under the too big to fail doctrine, we have every right to expect him to pay every single one of them. 70% of the economy is clearly too big to fail. And the majority of consumers do not have MBAs or PhDs like the "sophisticated investors" who work on Wall Street -- we are far more deserving of help. Where is our bail out?


    Or, we could follow the ideas that once made America the great country it USED to be (and could be again). Let the people who made poor investments bear the consequences of their decisions.

    If you traded with Lehman or WaMu or whomever -- you get the results of your decision good OR bad. If you make money, its yours. If you lose money, its also yours.

    Of course, this means a lot of Wall Street will fail. But they are hardly "victims" of anything, except their own decision making.
    Reply
  •  
    Sep 10 04:51 PM
    Jason C,

    Those "institutions&quo... and "creditors" mostly include communist China, jihadist Saudi Arabia, and fascist Russia. They are grown up investors, just like anyone else, and should have known that bonds can and do lose money. Companies default. It happens to investors daily. These particular bonds were bets that the U.S. housing market wouldn't decline, an event that has happened several times before, despite having run up at a faster rate than has ever occurred.

    The fear was that if the Chinese, Russians, and Saudis ever actually lost money on a US bond investment, they would refuse to accept dollars from then forward and our economy and currency would collapse from a lack of their debt. However, who would the Chinese, Russians, and Saudis sell their products to without the U.S? They have to trade with us, in dollars, or they would destroy their own economies. They could take their lumps and be all right, yet they had enough influence to persuade the govt. to confiscate the wealth of taxpayers by shifting these losses to them. Did the government socialize the losses of technology investors, who were mostly taxpayers, in 2000?

    The fact that the government forced these bond losses onto taxpayers just shows how much influence the national debt has on the decision making process.

    Assets = Liabilities + Equity

    Government = Foreign Debt + Taxpayer Equity

    Because liabilities account for a larger portion of assets than equity, the assets are being used to pursue the interests of the owners of liabilities instead of the owners of equity. Foreign debt keeps the government in business. Therefore, whether taxpayers like it or not, government serves the owners of foreign debt.
    Reply
  •  
    Sep 10 04:53 PM
    The title of this article is very nice:

    Distinguishing Between Out of Favor Sectors and Doomed Ones

    But we also have to look at Favor Countries and Doomed Ones.

    Let me give you link and quote:

    ft.com/cms/s/0/e30472a...

    The price of credit default swaps on five-year US government debt hit a record 18 basis points in early trading, according to CMA Datavision. This means that it costs $18,000 a year to buy insurance on $10m of US government debt.

    Comment: So I just had to advice to the European pension funds to buy this cheap bond insurance while the issuer still is alive.

    Remember those bond insurers where USA municipals could buy AAA ratings on their issued bonds?

    They are gone.

    Remember Freddie and Fannie that were supposed to guarantee the mortgages?

    They are bailed out...

    What will happen to idiots who sell US government bond insurance at only 18 basis points or just 0.18%?????

    Municipal bond insurers ==> Frannie ==> 18 basis points on five year US government bonds.

    Who knows?
    Reply
  •  
    Sep 11 10:31 AM
    The real cost of bailouts should be bourne first and foremost by the people running the companies being bailed out. Until a CEO and his handpicked board of directors go bankrupt along with the company, we will have no moral hazard. Instread the best paid job continues to be the CEO of a bankrupt company.
    What we need is the embrace of a new compensation scheme whereby executive officers and boards of directors are directly responsible for a portion of the company's debts that is related to the amount of stock rewards and compensation they receive.
    Of course you may say no one in his right mind would take such a deal, but everyday people take such risks- they're called small business owners!
    Reply
  •  
    Sep 11 12:34 PM
    Good point "just a hick". There are lots of us "law and order" types, who have been pushed too far by the exit packages at Fannie and Freddie and hope that the government just says no, regardless of contract provisions.
    Reply
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