Look stupid. Be brave.
Stock markets are designed to make smart people feel stupid, to take money from the fearful and hand it to the brave.
The last time the United States went through a major financial crisis, in the early 1990s, property markets on the West Coast were rocked.
Just like today, investors went running from the banks most exposed to worst-hit areas. San Francisco's Wells Fargo & Co., with its huge book of loans in California, was in dire straits. Or so people said. In the span of a few months it plunged 40 per cent; it was described as a "dead duck" and thought to be a possible bankruptcy candidate. Into the maw of pessimism stepped a well-known and very rich investor, who bought millions of shares. But still it kept falling.
Ah, well, sneered a columnist in Barron's, at least the guy "won't have to worry about who spends his fortune much longer; not if he keeps trying to pick a bottom in bank stocks." The investor? Rumpled old man from Nebraska, goes by the name of Buffett. And he did pretty well on his investment in Wells Fargo.
Like every other bank, Wells has been bruised in Wall Street's Black November. It's one of the lucky ones, since half the U.S. financial sector is in a body cast.
When an analyst at a major brokerage house speculates openly about the potential bankruptcy of the firm across the street, as Citigroup's Prashant Bhatia did yesterday with E*Trade Financial Corp., you know we are in the middle of an unusual time - the kind of market in which the brave inevitably look stupid for a while, but end up making a killing.
E*Trade's fall is stunning. In 1999, at the peak of the Internet lunacy, it was (very) briefly worth more than the Bank of Montreal. Now it's worth less than little Canadian Western Bank. Not five months ago, two hedge funds asked - no, demanded - Ed Clark to get out of the way and let TD Ameritrade, the Toronto-Dominion Bank's partly-owned U.S. brokerage, merge with E*Trade. Since then, the latter has lost about $8-billion in market capitalization. Where are the hedge fund geniuses now? Awfully quiet.
But the reasons for E*Trade's implosion - regardless of whether it goes bust - are the same reasons to be bullish on the U.S. financial sector. The company's big problem was management's decision to diversify away from what it was good at (online trading) into what it was demonstrably not good at (lending money).
Last year, its banking subsidiary wrote off about $45-million (U.S.) in bad loans; this year, it will be $338-million, Mr. Bhatia predicts, rising to $400-million in 2008. It's knee deep in toxic debt and management's credibility is shot. If it survives, the memory of its mistakes will linger.
So E*Trade's days as an aggressive lender are over, as it becomes the latest in a parade of financial institutions to pull back - even the big ones. HSBC Holdings PLC, the massive global bank, closed some of its subprime lending operations in the U.S. Lehman Brothers Holdings Inc. did likewise. Bank of America Corp. is chopping jobs in its corporate and investment bank. Citigroup Inc., which is in disarray, may break itself up or close or sell divisions. At the least, it's will have to become far more cautious as it rebuilds its wafer-thin capital base.
It's the same dynamic Mr. Buffett took advantage of in the early nineties with his Wells Fargo play. Then, as now, the weakest competitors died or went away, which, in any business, including banking, tends to mean higher costs to the customer and higher margins to the survivor.
The yield curve is also changing. U.S. banks typically make money by borrowing short term and lending longer term. The U.S. Federal Reserve is responding to the current crisis by cutting short-term rates (that is, banks' funding costs will fall). But the rate banks can charge for longer-term loans is higher, because credit spreads are wider.
That can only mean good things for bank profits. So why has the world gone so negative on Wall Street? Why do most of the really excellent banks in the world's largest economy sell for 10 or 11 times earnings, and Citigroup and B of A have yields around 6 per cent?
There are two reasons. The first is that the mortgage mess is not over. But the second is what Bill Miller, the famed mutual fund manager at Legg Mason, might describe as predictable, but illogical, market psychology.
Studies repeatedly show investors place too much weight on information that's (a) recent, and (b) dramatic. The multibillion mortgage writedowns at U.S. banks are both.
Mr. Miller, who beat the Standard & Poor's 500 for an incredible 15 consecutive years, has been getting enthusiastic lately about U.S. financial stocks. At the moment, he looks foolish and stupid. Two years from now, he'll be thought of as brave and wise.
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