Birinyi compiled all of the 2010 strategist forecasts and calculated the following averages: a yearend S&P 500 target of 1,222, $76 in S&P 500 earnings, and 3.1% GDP growth. The deviation from these averages was not wide. These numbers might be plausible if this were a typical rebound from an inventory-led recession. But this is not what we’re experiencing.

Just consider today’s weak nonfarm payroll report. Government number crunchers estimate that the economy lost 85,000 jobs in December. Of course, this figure is highly massaged by seasonal adjustments and the “birth/death model,” which assumed that new businesses created 59,000 new jobs in December. Without the birth/death adjustment, the headline would have been 144,000 jobs lost.

The civilian labor force participation rate fell to a new low — 64.6% — as more discouraged workers give up looking for jobs. If these workers were considered by the statisticians to be looking for jobs, the headline unemployment rate would jump several percentage points.

To gauge the accurate health of the labor market, check the tax withholding figures. These figures are still down significantly year-over-year.

Job creation needs to turn highly positive quickly to justify the valuation of the stock market. The employment picture is also vital to the health of the credit markets and the banking system. The popular obsession over how long the Federal Reserve is going to hold short-term rates at zero distracts many investors from the destructive influence that high unemployment will have on credit quality.

The Fed’s extremely loose policies have sparked investors to take on more credit risk in the secondary markets. This has pushed up the prices of junk bonds and junk stocks, lowering yields. But if the labor markets don’t rebound dramatically from here, we’ll see accelerating credit losses on everything from mortgages to credit cards. Those who piled into junky credits due to zero interest rate policy will flee out of them due to rising defaults.

We’re in uncharted waters when we combine stubborn labor market weakness with heavy private sector debt loads. Credit losses are likely to surprise the market on the upside in 2010. This is especially dangerous for a banking system that’s marking its own assets at “mark-to-myth” levels.

Through several examples, it’s clear that the Treasury Department’s unofficial policy for dealing with underwater real estate loans is “extend and pretend.” This means that as long as underwater borrowers are making monthly payments, most bank examiners will look the other way and allow banks to mark loans at artificially high values. Bank regulators are also likely to look the other way if banks roll over maturing loans that are underwater on a mark-to-market appraisal basis.

But this isn’t cause for celebration. Instead, this mass denial of reality will only make the ultimate credit losses even larger. But this seems to be the policy, because it’s politically expedient and painless (for now).

Just like we saw in post-1990 Japan, “extend and pretend” will commit huge amounts of scarce capital in the banking system to defend bubble-era loans. Instead of extracting this capital out of bankrupt situations to be reinvested into new loans, we’re prolonging a misallocation of capital. By defending and maintaining old underwater loans at unreasonably high marks, most banks won’t have much room on their balance sheets for new lending. This one consequence of “extend and pretend”: continued tightness in lending for small businesses, which are the biggest job creators.

A Correction in China Looms

It’s likely that the growth we saw in emerging markets in 2009 will decelerate. China’s infrastructure-heavy stimulus package put Chinese people to work and boosted commodity imports from resource-rich countries like Brazil and Australia.

But this stimulus package is leading to excess capacity in real estate and many heavy industries like steel. It’s also gone hand-in-hand with mind-boggling growth in bank lending. Rapid growth in bank lending always leads to trouble.

So the People’s Bank of China (PBOC) is just now tiptoeing towards a tightening policy. The PBOC seems worried about the real estate bubble that’s now becoming more obvious in major Chinese cities. Earlier this week, the PBOC sold three-month bills at a higher (rather than lower) interest rate for the first time in 19 weeks. This is a clear signal to the heavily state-influenced banking sector that it should tighten its loose lending policies. Much of this lending went to finance large infrastructure projects deemed by (often corrupt) communist bureaucrats — not the free market — to be necessary.

This kind of activity can go on for much longer than logic would dictate, but eventually, misallocated resources become too obvious to ignore. Just as the U.S. housing bubble continued a few years beyond when it became obvious (say, in 2005), so can the excesses in the Chinese economy.

The potential catalysts for a correction in China are many, but the most likely would be continued escalation of trade protectionism. This protectionist trend could offer several attractive short ideas in 2010. For example, on Dec. 30, The U.S. International Trade Commission ruled that growth in imports of Chinese-made drill pipe and casing materially injured the U.S. steel industry. The commission imposed 10%-15% tariffs on imports of Chinese steel pipes, with the possibility of further tariffs in the coming months. The Chinese government is allegedly subsidizing its steel industry. This is probably true, but China will likely respond with its own protectionist measures anyway.

The interference of governments into free trade — in the form of both subsidies and tariffs — is not good for the future of globalization. Many of today’s big transnational corporations are built on the assumption of unending globalization. These big corporations are establishing closer ties to politicians around the globe, and many are seeking to game the system or pursue government subsidies rather than serve their customers.

Regards,
Dan Amoss

January 15, 2010

Why We’re Still Headed for a Correction at Home and in China was originally featured in the Penny Sleuth.

And that financial malady is now traveling to Main Street as banks – including the latest FDIC rescue operation here in Baltimore on Friday – crumble all around us. Here’s what you need to know to profit from this mess…

The market’s mood can swing between mania and depression over short periods of time, but over longer stretches, stock prices eventually reflect the real value of underlying businesses and whether that value is growing or contracting.

Many stocks will not revisit their lows forged during last fall’s panic, but many others will break to new lows. Right now, the market is positively giddy about the future earnings streams of banks and thrifts and has bid the stocks up in anticipation of a miraculous economic recovery…a recovery that will be weak and limited to few sectors – certainly not including consumer finance, retail, and real estate.

The next move in the financial stocks will be down and regional banks and thrifts will lead this move. As Chris Whalen, a leading authority on the health of the banking sector, notes in the lead quote above: “In bad periods, banks typically set aside twice as much as they charge off, but now a lot of them are at one-to-one.” Most banks are reluctant to book the provision expenses necessary to maintain loss reserves, because this cuts into net income. But delaying recognition doesn’t mean they’ll go away; delay just means that losses in the future could be bigger and exacerbate the trend toward tighter credit. The market for bank stocks is not discounting this development right now, but it will over time. None of these smaller institutions are “too big to fail,” so many will be resolved by the FDIC, and acquired or liquidated.

This month, we’re shooting for 150% gains in put options on a thrift that strayed from its humble roots and is now dangerously undercapitalized.

What we usually do in Strategic Short Report is a form of “time arbitrage.” We recognize that euphoria can push the stocks of capital-destroying companies far above what they’re worth and we take opportunities that the market offers to sell short over a time frame when we expect common sense to prevail and prices to fall. Sentiment toward the financial sector is positively giddy right now, and stock prices have rallied to levels that discount a swift return to happy days and tiny credit losses. But the recession is over, right? No way, if you’re measuring it honestly. And for the banking sector, it’s definitely not over.

Bank Profits Cannot Grow When Balance Sheets Shrink

Now that we’re in a new ice age for the financial sector, many banks will be shrinking their balance sheets. This shrinkage occurs as healthy borrowers pay down debts and are not interested in taking on more debt. With so much excess capacity in so many industries, why should entrepreneurs with good credit look to expand? Especially with the guarantee that if they grow, these entrepreneurs would be, in the eyes of a cash-strapped government, an even juicier source of tax revenue?

This is bad news for banks, because growing private sector demand for credit is the key for banks looking to “earn their way out” of their festering losses.

Such is the paradox of runaway government spending, which is so massive that it’s temporarily boosting GDP figures. But this spending is ultimately self-defeating: The more the government spends, the more the private sector will tap on the brakes. In my view, this is the weak link in Keynesian policies, which Washington, D.C., policymakers keep pursuing aggressively. The federal government is the only notable borrower with growing demand for credit, so lots of banks will wind up buying the bonds of a spendthrift government – hardly the kind of lending that infuses cash into productive private investments and private sector jobs.

This leaves the banking system in a situation in which most borrowers seeking new loans or refinancing are not good credit risks and the borrowers who are good credit risks are not interested in more credit. And let’s not forget the elephant in the room: residential mortgages. This is a problem that cannot be resolved by just refinancing at low rates, or extending terms, because most homeowners with mortgages do not have enough equity to refinance.

The biggest mistake the banking system made was believing that the average value of U.S. houses could never go down. This mistake would have been avoidable with a bit more free market discipline in the banking system, which would have slowed credit flows into mortgage lending once prices had detached from median incomes. It also would have helped if mortgage originators were required to retain a portion of the credit risk involved with each new loan.

Bankers aren’t the only ones to blame. Policymakers made a grave mistake by pursuing the goal of homeownership for everyone. They did not distinguish between homeownership and a “call option on homeownership,” which is a more accurate definition for a low- or no-money down purchase. With the benefit of hindsight, we know that not only did these call options on homeownership expire worthless, but with the smidge of equity gone, the incentive for many homeowners to keep making mortgage payments is also gone.

There are a few more assumptions that fans of bank stocks are ignoring at their own risk. These fans are looking at the experience of the sector during the early 1990s to draw conclusions about the likely trajectory of credit losses, recoveries, and spreads on future lending. They foresee a period of consolidation, followed by a return to the pleasant lending environment.

These bulls are misdiagnosing the situation, and here’s the main reason: The banking system has no experience managing through the current “negative home equity” environment. This is an environment in which mortgage rates are already about as low as they can get and consumer balance sheets are as stressed as ever. Due to the nonrecourse nature of mortgages, most borrowers have no financial incentive to keep paying. Many are choosing to mail the keys back to the lender.

This problem will cap the upside of bank stocks for years to come, and this sector will offer lots of short selling opportunities.

Regards,
Dan Amoss

August 31, 2009

The Ugly Truth About Bank Stocks was originally featured in the Penny Sleuth.

No one thinks they’re doomed.

I’m talking about the Canadians, of course.

See, lately, I’ve read a lot about the superiority of the Canadian banking system. And naturally, my contrarian instincts prompted a search for a way for you to make money as the Canadian banks go down.

As you may know, an easy way to play the downside of stocks is through put options. Here’s a quick primer on how they work…

Put options are a limited risk, leveraged way for you to make money when stocks drop.

For example — when a stock falls 5% in a day, put options may go up 50%. When big drops happen, puts can go up hundreds of percent in hours.

And since they’re limited risk, if you’re wrong, you’ll never lose more than you put up.

My point is — there’s no easier, safer, and faster way to grab huge gains from downward stocks than through put options.

Having said that, let’s take a look in on how you can use them to make money on the Canadian banks. First, the “macro view…”

The Canadian banking system has won accolades for avoiding direct exposure to the most tempting forbidden fruit: products like subprime mortgages, credit cards, leveraged buyout loans, and loans to finance insane commercial real estate purchases.

The financial press loves Canadian banks. On May 19, The Wall Street Journal ran a piece suggesting that these banks are a model of sustainability, and now have the opportunity to acquire U.S. banks on the cheap:

“Not long ago, Canadian banks were considered slow footed, provincial, and too conservative to flourish in the global boom for financial institutions. Now that banks in the U.S. and Europe are reeling from loan losses and face growing government scrutiny and ownership, Canada’s six major banks are seen as a potential model for battered financial institutions. TD Bank, Royal Bank of Canada, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce, and National Bank of Canada posted more than C$3 billion (US$2.5 billion) in combined profit in the latest quarter.” [Ed. note: quarter ending April 30, 2009.]

Canada’s biggest six banks account for more than 85% of the assets in the country’s banking system. By and large, these banks made a smart decision to avoid securitization. Securitization refers to loans that banks originate, bundle together, and sell off to pension funds, money market funds, insurance companies, and other institutions.

But this doesn’t mean that Canadian banks have no credit risk. On the contrary, they have plenty. Mark to market accounting has not yet cut down Canadian bank earnings, because the Canadians have not yet accounted for the impending wave of mortgage, consumer loan, and corporate loan losses.

They will by the end of 2009. It’s impossible to avoid. And just to give a perspective on how quickly lending grew at the Canadian banks, the chart below shows that assets at the top six Canadian banks grew from C$1.3 trillion in October 1999 to C$2.7 trillion in October 2008. Equity at these top six banks grew in line with assets; all six kept their ratios of assets to common equity fairly constant since 1999.

Growth in assets, even if accompanied by growth in equity, is always a risky proposition for banks. At the time the loans are made, everything seems fine. Then, when a serious recession arrives, and a dramatic credit loss cycle begins, the market value of loan portfolios can rapidly decline by 5% or 10%, pushing the banking system to the edge of insolvency. Insolvency is when the value of assets is less than the value of liabilities. Bank regulators don’t like this scenario and pressure weaker banks to raise very expensive, dilutive equity capital in order to protect more senior lenders, including depositors, from suffering losses.

Canada has just entered what will ultimately be an enormous credit loss cycle, and by the time it’s over, the Canadian banks could easily lose their pristine reputations. Until the middle of 2008, Canada’s economy was booming. Its mining, energy, and manufacturing sectors are world-class, and every other sector was pulled along for the ride.

But the wheels fell off last fall. According to Statistics Canada, the unemployment rate rose to 8.4% in May — the highest in 11 years. Ontario, with its heavy manufacturing base and ties to the “Detroit Three” auto companies, is especially hard hit; Ontario lost 234,000 jobs, or 14% of its entire manufacturing work force, since last October. Ontario will lose even more jobs this summer as GM and Chrysler dramatically cut auto production. Alberta has slowed dramatically too. Just a year ago in Alberta, every skilled construction worker was working overtime on oil sands projects. Now many projects are postponed and workers are getting laid off. The unemployment rate in Alberta nearly doubled from May 2008 to May 2009, to 6.6%, and is heading higher.

For Canada, this credit cycle will probably be worse than the one in the late 1980s. According to RBC Capital Markets, annualized loan loss provisions for the entire Canadian banking system peaked at 2.88% of all loans in 1988. As of April 2009, this figure was just 0.77%. Over the next year or two, loan loss provisions should easily triple or quadruple, which would cut deeply into profits and capital… sending the worst of the Canadian bank stocks down.

So how do you play it?

First, I recommend you dig in to the major banks to figure out the one with the most exposure to unemployment rates. Then, simply visit Yahoo! Finance, enter in their symbol and click on “options” on the top left hand side underneath “Quotes.”

You’ll see all of the put options available on that stock. Pick a good one and you’ll be able to double your money as these stocks go down.

Regards,
Dan Amoss

August 12, 2009

How to Play the Canadian Banking Crisis for a Quick Double was originally featured in the Penny Sleuth.

And I’m going to give you a chance to join them.

If you think Canada escaped the downward trend in U.S. banking, think again. While the country may not have plunged headfirst into subprime mortgages, it did dip heavily into risky derivatives. The leverage it took on generated impressive returns on equity in good times, but that same leverage is set to wipe out equity today.

Shareholders in one “safe” Canadian bank will have to rethink their loyalty. Its looming solvency crisis practically guarantees a dividend cut. And that’s our catalyst for this month’s short play action – offering us a chance for 200% profit potential.

Accounting secrets have not yet obliterated Canadian bank earnings – like those of U.S. banks – because the Canadians have not yet accounted for the coming tsunami of mortgage, consumer loan, and corporate loan losses.

Here’s how they loaded those loan books with hidden risk.

The Basics of Bank Accounting

Bank shareholders leverage their capital by borrowing short-term money, primarily from depositors. Your bank account is an asset for you, but it’s a liability for your bank. For every dollar of capital, bank shareholders borrow 15, 20, or even 30 dollars from senior creditors – otherwise, they could not afford to own their huge portfolios of loans and securities. Here’s the core problem: Bank shareholders and their agents (bank executives) are lending other people’s money. So bankers are looser with lending than if they were lending their own savings.

The accounting process to determine commercial bank profits is inherently speculative, as well. Banks book an upfront profit on every new loan they make, minus a small “provision” for loan losses – just in case some loans wind up going bad. These upfront profits have the habit of disappearing when loans “season,” and banks discover how many deadbeats owe them money. In case you’ve been wondering what has wiped out the majority of the S&P 500′s trailing earnings, here’s your answer: Banks and brokerages reversing most of the profits they booked on loans made and securities bought at the peak of the bubble.

Banks claimed to make good money loans to every borrower. But somebody sure was lying, since they’re taking charges against these older vintage loans and securities left and right. And the industrywide provision for loan losses, which is the single most important – and unpredictable – cost in a bank’s income statement, has been soaring. Once these provision expenses soared on the backs of delinquent loans, the banking sector’s earnings plunged deep into negative territory.

Throw in a few more explosive ingredients like deposit insurance, central bank lending facilities, loan syndication, and securitization and we’re left with a system for which sales volume – not risk management – is priority No. 1.

Those who claim the banking system is well capitalized – including those who designed the unstressful “stress test” – hold rosy assumptions about how many loans will go bad and how much banks will earn from existing loans to have a shot at outrunning their credit losses.

Lots of bank stocks remain in a fragile state. This month, we’re going to buy puts on the Canadian bank most ready to fall. And now’s your chance to join us. If you want the name of my latest play, just click here to learn more about Strategic Short Report.

Regards,
Dan Amoss

August 10, 2009

Don’t Bet on Canada’s Banks was originally featured in the Penny Sleuth.