Conundrums and Stress Tests

May 11, 2009

Good morning. It was yet another solid week for the market, especially big caps, last week. The SPY had a very strong move from 97.89 to 92.98, or 5.8% (and now positive on the year), and the Industrials were up 4.4%, from 8,212 to 8,575. The QQQQ’s, however, were actually down slightly on the week, from 34.37 to 34.23. To some extent the rally was concentrated in oils and financials, and the de-coupling with the QQQQ’s may signal that some caution should be considered after the rapid run-up. The VIX continues to show an increased comfort in the market, as it was down over 10% on the week, from 35.29 to 32.04.

On the client level, communication from clients indicates a willingness to be more fully invested now than really at any time in the last several months. There is no question that the market feels better now than in March, but the SPY is also now at 92, not 67. That is the real conundrum in being an investor; the market usually feels the worst when it is at the best value. Normally fully invested people are unable to buy at the market’s best prices because they are being seriously hurt and have little buying power, in fact some liquidation is usually the result. Our people in the PIP program had the means to buy because losses were limited, but still it was difficult to stare a market collapse in the face and commit every dime. We were able to get a little more invested by rolling down protective puts, and were able to withstand the temptation to liquidate. It is easy to forget the feelings of eight short weeks ago when the investment world looked like it was coming to an end. Some of the positions we were able to put on outside the program, yielding huge percentage returns, were put on in stocks that had a solid chance of not lasting through the weekend. It would be foolhardy to just count the winners without remembering the feeling, the circumstances, and the risk involved at the time.

The big news of the week, and the subject of seemingly endless opining by talking heads, was the big “stress tests” of the nation’s largest banks. As a way of disclosure, in a previous life, I was what used to be called a Financial Analyst, and a large part of my job was to do what used to be called “sensitivity analysis” of new contracts, large capital projects, etc. In essence the idea is to take everyone’s assumption about a project and jiggle it a little bit to find out how “sensitive” the bottom line on a project was to bad estimates. For instance, what would happen if the build rate was off by 15%, or the cost of purchased parts off by 8%, etc. I usually found, and actually a little trick I used often, that projects could usually hold up to big relatively big moves in one variable but if you tried small changes in estimates in multiple variables the project usually failed. For instance, you might say the project (like a railcar design/build) would start a month late (not much), have a build rate 5% slower than estimated (again not much), purchased costs off 3% (within anyone’s good job range), but the sum of a lot of little misses in estimates was usually devastating to the bottom line.

What does all this mean? It comes down to how good of a job, and even if the job was doable, did the analysts do on these bank tests. Start with the idea of a few governmental employees, probably young, walking into a place like Citigroup with over 300,000 employees, and saying “Give us the stuff.” Continue with whether these people had the time and the freedom to do the job right, something I would seriously doubt, and whether they had the imagination to move multiple variables like I used to. End with the leaked stories of the large debates waged between these government employees and the banks senior management over the final numbers (BAC’s original number rumored to be $50B, reduced to $34B after raucous meeting with management). I would doubt very seriously that in any instance there was time to actually sample the housing situation, the credit card situation, or the commercial construction impending fiasco. I would shudder to think what things would look like if you added a credit card interest cap of, say, 22%, or some real credit card bill of rights, or an increase in CD rates to say, 5%, or interest on demand deposits to 2.5%. Yikes!

What really happened politically? Despite every talking head’s hand wringing regarding Japan-type zombie banks, that is exactly what happened. The system was crashing several months ago, probably to the tune of $3.5T in real losses. The Fed and the Treasury were able to flood the system with roughly half that amount, still leaving the system grossly undercapitalized if every bank was forced to write everything down at once. However, it was enough to save further short-term meltdowns (so far) and banks were able to show this first quarter that their franchises (essentially an oligarchy) were strong enough to generate strong income even with their decimated balance sheets. There is no reason to go further, it is a risk but surely one worth taking. Go in, do some sort of an examination that essentially determines if the bank can bump along and over time heal itself, given the incredible ability they have to make money on normal business. The answer appears to be yes, with the exception of a couple of places (BAC and WFC) that have recently made large acquisitions. But so far they are saying that the total system (again, a zombie system, not full health) is so far under $100B. That is an incredibly small number compared to the $1T or so most feel the system is still light.

What does that mean to our trading? It means the banks will be revalued from prices reflecting imminent closure to prices more appropriate to long term survival. Banks like Fifth Third were violently revalued from a (might not last the weekend) price of $1.01 on 2/20/09 to $8.49 last Friday. Are they capitalized like we would like to see a healthy bank? I think not, and probably are a long way away from showing health in the way of a really sound balance sheet and dividends to investors. But they are a good bet to survive if the recession does not “double-dip”. But will we “double-dip”, with the employment picture the way it is (add the revisions of around 60,000 to the governmental hiring of 60,000 census workers gives a number of minus 750,000 for the month)? We better hope not, but too soon to declare victory. As for the market, I plan on keeping our short calls closer to the market for a while, I think this rally might be getting a little overdone. We actually have come so far so fast that the thought of a downside correction is certainly a possibility.