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An Oligopoly Outbreak

April 27, 2009


Good morning. Two solid days for the market last Thursday and Friday almost brought the SPY into the positive for the week, but the rally fell short at 86.66, leaving the SPY down .74, or less than 1%, on the week. There was a fairly significant increase in the VIX, up from 33.93 to 36.81, possibly due to a combination of concerns involving financial stress tests and a possible worldwide flu outbreak. Last week was dominated by earnings reports, and if you are from the school (as I am) that is impressed if a firm is able to make money in a pretty challenging quarter, it was a good week of news. Certainly the positive performances on Friday in American Express and Microsoft were cause to take notice. This morning, early, the spreading flu virus is being blamed for a sharp sell-off in Hong Kong, a mild sell-off in Europe and a fairly sharp decline in futures here.

It is been quite a year so far, and it is not yet May. The SPY started the year at 90.24, made a low of 67.10 on 3/6 (down 26%), has bounced back 29% to 86.66, and now rests (momentarily) down 4%. Unless you have a hedged portfolio (like the PIP) it has been a four-month stretch not for the faint of heart. It is also possible that the market caused so much pain down hard in March that people liquidated at those levels, and have missed the markets bounce to almost even on the year. The question is, now what? Until last week the declining VIX was indicating the market might be entering a trading range, maybe one with quick moves within the range, but a range nonetheless. It is also consistent with a seasonal pattern that traditionally has the market (again, only a seasonal pattern until you bank on it) in a fairly benign state roughly from May expiration until the 4th of July. In my 17 years in the OEX crowd it was usually difficult to maintain a balanced position in early May as the predominant order flow was to the sell side on options. You had to really be careful to not end up long a lot of premium going into the holiday/summer season. I believe the phrase was “Today’s bid is tomorrow’s offer.” Again, the operative word here is *usually*, and the market the last couple of years has been anything but usual. In fact, we have had significant moves in 2007 and 2008 in the normally very quiet two weeks between May expiration and Memorial Day, and now we have a possible flu pandemic. Can anything else happen to mess up this market? Maybe an earthquake or asteroid hit to add a little excitement, or a plane being chased by an Air Force jet over the Hudson?

I think everyone has found interesting the battle raging on all fronts regarding the banks, and the TARP, and the amount of influence government should have over the banks’ “business,” the credit card issues etc., etc. Again, depending on your point of view or political affiliation (or your actual or hoped for station in life) everyone has an opinion as to how it should be handled or who to favor. I find it as an amazing lesson in business and people behavior, and how people behave in industries that have been allowed to become less than competitive. It also is a lesson to government, should they wake up and see it, of how difficult it is to rule by dictum all the checks and balances normally handled by the competitive process. For instance, we (meaning every talking head with a mic) debated ad nauseum the outrage that government would dictate how much money bank executives could make, and whether they should raise credit card rates on those that essentially had just bailed them out. Here’s the problem, and how screwed up the “system” has become. The executives complaining are pointing fingers at government as influencing executive pay, but I think they really are outraged that anyone could reign in the abuse. Like it or not, the government is a serious “owner” of some of these banks, and all owners should have influence over how much employees get paid. I don’t agree that “ownership” is the long-term role of government, but that is not the problem. These people don’t think anyone should be their boss, and that goes for any “owner,” government or not. People like BAC’s Lewis or Goldman’s Blankfien are used to picking rubber stamps for Board members that are so far from representing “owners”, meaning shareholders, that it is not even a consideration. All one has to do is look at the relative losses and gains between shareholders and executives (and in some cases Board members) in the last few years to see how out of whack the system is. It certainly seems that in a lot of cases the Executives get the bounty in good years, and the shareholders absorb the losses in bad. That is certainly why, even though I am a long-term supporter of investing, I am a firm believer in protecting yourself in the investment process (at least until the inequities are fixed).

In regards to lack of competitiveness, the modern example of what happens when competition is allowed to lessen and an oligopoly to form is going on before our eyes. The amount of major credit card suppliers is down to around six. I am sure every one of you has had at least one credit card that has been “gobbled up” one way or another by one of the remaining firms. I, for one, had a card with Providian Bank, which was bought by Washington Mutual, which was now merged with Chase. I have a Sears Master Card, which is now Citi, etc. Can anyone remember the First National Bank of Chicago, with one of the first Bankcards? Also, I can’t imagine any one of you not getting something in the mail notifying you of a change in your credit card agreement (and not a positive change). Anyway, if things were anywhere near competitive, if Chase had a problem and felt like raising rates, customers would just move to a different bank and a more competitive rate. In an Oligopoly, it is more likely that the other banks would use the opportunity (or worse, actually discuss the situation) to raise rates in lockstep. Imagine, if you will, if the government would, on purpose or through inattention, manage to limit the number of restaurants to a non-competitive few. Just think of the myriad rules, prices, portion sizes, cleanliness rules, etc. someone would have to think up to try and match the efficiencies built into a competitive market. What a mess! Now we (meaning the government) is trying to simulate what a competitive situation would look like in an industry that is no longer competitive. It is way easier and more efficient to just maintain competitiveness in the first place. Answer? Absolutely no more mergers among large banks with credit card groups, increased TARP money to any smaller bank willing to enter the business, and (unfortunately, and hopefully temporarily) some sort of federal usury law.

So does that mean we buy Bank stocks? I think a lot of you have noticed that we have been bullish on the XLF for some time. This “Banking” ETF has bounced back from a low of around $6 to around $11, a huge bounce of 83% in an index. I believe that the large Banks have been given, and continue to receive, virtually everything necessary to plod through towards survival and eventually prosperity. We sure do not have to love them (thank God) to profit by them. It is still necessary to remain careful, however, as problems in construction lending, credit card lending, etc. are still forthcoming. I just believe that a careful investment in the XLF (with corresponding call sales) is a solid bet at these levels. I also believe that it is worthwhile to look at a lot of the companies that had positive earnings last week (many in the technology sector), being able to stay in the black in this environment means that not every management team is inept. It is also probably a good idea to watch those drug companies that move quickest to deal with this new flu issue, if it starts to spread the first with a vaccine should do well. Right now GlaxoSmithKline’s Relenza and Roche’s Tamilfu appear to be the front line of defense.

I would certainly welcome comments on the Blog. These issues we are facing in the Economy certainly seem unique, but really a lot could be expected based on various policies of really the last five Presidents. A lot are due to excess industry concentration, a lot due to a curious but dangerous lack of individual morality at high levels (government, business, you name it). Anyway, it does not mean that we cannot invest profitably, and in some instances it actually helps.