Stock Gurus: Bill Miller

Legendary stock guru Bill Miller appeared on CNBC today. He manages a Legg Mason fund, and holds the record for beating the S&P (15 years), until the crash of 2008, that is. His portfolio has since rebounded as much as 40-80% (depending on what you’re looking at).

Mr. Miller is just behind Warren Buffet in the world of value investing. I respect his opinion, but like everything else, I think you have to keep things in perspective. For example, if you’re down 70% one year, and then up 100% the next year, you’re still down 35%. So don’t let these percentages fool you.

Also, you have to keep in mind that value players favor looking at valuation, which creates a bias. In Mr. Miller’s case, he may tend to underestimate the macro picture. I’ll give two examples. The first is real estate. Mr. Miller is long real estate and argued for a recovery. He’s down on that investment – he joked about being “early”. But oddly, no one on the desk of reporters (which is why I think it’s such a shame that reporters are asking questions) asked what happens when interest rates go up. Real estate will go down again, I believe, and how much depends on how much inflation there is. If that’s true, it means that he’s very early on real estate, the cycle isn’t over. On the same day, Professor Shiller of the well-known Case-Shiller Index admitted that there’s better than a 50% chance that real estate prices will go down again.

The other example lies in the 2008 crash. Mr. Miller didn’t see it coming, and that’s because he was looking more at valuation (price-to-book, PE, etc.) than at macro trends (in my opinion, he didn’t say that). In this interview, admitted that they’ve learned a lot. Before, he would have said that the depression scenario was off the table. Now, he has a different view: there are two different kinds of downturns – liquidity , as in 1987, when the Fed pumping money into the system was enough; and asset or balance-sheet downturns, where the value of assets decline and this is what the Great Depression was. This actually makes lots of sense. Consider the post dot.com period, when savings went down, but employment held up relative to 2008; and individual’s assets – such as real estate actually gained. In 2008, both savings and assets took a hit. So that’s a good way to look at it, I think.

Mr. Miller does think that there are still great values in the market, and of course, that’s the interesting part. He believes that the worst is over, but the recovery is far from complete. And the risk after a major event such as the 2008 crash is relatively low.

Mr. Miller’s example was IBM, which trades at 12x this year’s (2010) earnings. The company has top line growth of close to GDP levels, so not much exciting there. It’s the bottom line that’s interesting – it produces cash, so IBM buys back stock and earnings go up. It has performed consistently, even in this down market. I agree, lots to like there, especially for retirement portfolios.

Other picks include regional banks, that are trading at discounts to book value with good capital ratios; GE, Walmart, JP Morgan (with earning’s power of $6 or so, implying a $60 stock at 10x PE); Bank of America (with earning’s power of $3.50, implying $35 stock at 10x PE); JNJ, Pfizer; Merck and MGIC (which provides mortgage insurance, trades at about half of what it’s worth, and will someday make money in mortgages again).

I am long General Electric, JP Morgan and Bank of America.

The Coming Week - July 13, 2009: Earnings at the Doorstep

So earnings really starts in earnest tomorrow, Tuesday, as Goldman Sachs reports. Other key companies reporting are Intel, Dell and CSX tomorrow; Best Buy and Yum on Wednesday; and Bank of America and General Electric on Friday.

Goldman will set the tone for the week. I fully expect Goldman to beat, and this morning, Meredith Whitney’s positive call on Goldman set off a 185 point rally in the Dow and a 22-point rally on the S&P. The rally also helped the S&P bounce off a key technical resistance level of 874.

The rally in Goldman sets up a bump in the stock going into earnings, and depending on how much Goldman beats by, there could be either a little more after earnings, or a sell-off on the news. There is a fair segment of the market that will argue that Goldman’s performance will be a one-time event, and that keeping it up through the rest of the year will be hard to do. I remain a long-term bull on Goldman, and do expect the company to beat earnings for the year. So I would look at any dip or sell off as a buying opportunity. My thesis is two-fold: first, Goldman makes money any time money is raised. So as long as there is activity, Goldman will be a beneficiary, either as a facilitator of equity raises, debt financing or even principal investing. Second, Goldman, as one of the last investment banks standing, will benefit from the fall of Lehman and Bear, and the flight of high-paid bankers from the remaining competitors. I see Morgan Stanley in a similar vein, although not as much of a risk-taker as Goldman. As one pundit called it, Morgan Stanley is Goldman Sachs light.

As for the other major banks – JP Morgan, Wells Fargo and Bank of America – they will all benefit from mortgage refinancings and restructurings, as well as from government support. Accounting changes may also benefit these banks. The commercial side should be weak, but the investment banking side (Wells will probably benefit the least, but Wells is planning on beefing up that side) should do well. Finally, the sale of assets, such interests in China Construction Bank, could bump earnings as well. On the downside, the repayment of TARP and share dilution will counteract some of these pluses. All in all, there’s a lot of “stuff” in this quarter’s numbers. I personally think that overall, the banks, in the short term, will not be terrible, and may even give some strength to the market.

In other sectors, we’ve lost the oil trade for the time being, and I don’t expect any earnings reports to be catalysts for the commodities market. Gold is weakening, and many believe that gold is headed toward the 880 range. The consumer will remain weak, and I find it unlikely that industrials will see a recovery around the corner. So at least, barring a surprise, I don’t see any short-term, predictable catalysts for commodities.

Tech remains an area of interest. In certain parts of the market, we have product cycles driving sales – smartphones (Apple, RIMM) and computers (Windows, Intel, etc.). Today, Dell put a damper on that product cycle by saying that Q2 margins will be lower and that customers are delaying purchases. Not a good sign, but it’s not yet clear whether that will be indicative of the next couple quarters. In conclusion, I think, of the stocks mentioned, Apple has the strongest product cycle, driven by iPhones and iMacs. I do think the Windows product cycle will give some lift to these stocks, although how much remains to be seen.

Otherwise, the remainder of earnings season should be mixed. Once we get past Goldman’s numbers, we will get some positives (perhaps the banks), but some negatives, like Dell today. Which way the market will go remains indeterminate, in my opinion, but now market direction is less important than picking winning stocks.

I am long Apple, Intel, Dell, Goldman Sachs, Morgan Stanley and Bank of America.

The Week Ahead: Monday, April 25, 2009

After a three-day weekend, the market faces a week highlighted by economic news, a possible GM bankruptcy and a huge volume - $101 billion – of Treasury notes coming to auction. In terms of GM, no one expects the bondholders to walk quietly into the night, making bankruptcy highly likely, regardless of what happens on the union side. Also, the economic indicators are expected to be weak.

So unless there is surprise in the economic indicators, the Treasury auction and the dollar the centerpiece of the week. The last Treasury auction was just a bit weak, and given concerns about the amount of debt that the US has, this week’s auction could be even weaker. That could set off a series of consequences – the dollar could continue to weaken; interest rates, especially in the longer dated maturities, could inch up; commodities would rise; gold would gain; and weak dollar plays such as Proctor & Gamble, Coke and McDonald’s could rise. Some say that all this might trigger a general sell off in the market, but that remains to be seen.

Should interest rates rise, that could also spark a reaction by the Fed , which would start buying securities to keep interest rates low. That’s because the Fed’s priority has to be to keep the credit market working, and that only happens if interest rates stay low.

What does all this mean for an investor? Basically, it’s a trader’s week, because things could move very quickly. We could head one direction and then reverse, depending on how things play out. If you’re placing bets, a quick trigger finger may be necessary.

Longer term, I’m still watching certain stocks as a long-term investment. For the financials, which have been under pressure lately, I’m looking to see how much further they may retreat, and whether they will fall below their recent secondary offering levels. Again, I’m looking to build a position in the financials over time (meaning, no need to commit everything now), the favorites being Goldman Sachs, Morgan Stanley, JP Morgan and Wells Fargo. Bank of America is interesting, but requires caution. All of these banks face the possibility of increased losses over the next couple quarters. While I think the disaster scenario is unlikely, pullbacks actually remain very likely.

Market Update

So it was fairly obvious that the market has been turning. We got a bit of a head fake Monday, but weak volume and selling into the close on Tuesday and Wednesday should make today's retreat no surprise.

I'm looking at the charts this morning, and it looks to me as if we have resistance around 8,000 on the Dow, 850 or so on the S&P.

For the financials, we have to start looking at individual charts to determine entry points. Generally, though, I think that we should look for opportunities in the diversified, big banks and trading houses - GS, MS, JPM, WFC, BAC. The investment banks, GS and MS, will do fine and will benefit from being the only two true investment banks standing. JPM, WFC and BAC are diversified, so while they will be hit by credit cards, loans and commercial loans, they will make money from other business lines, including refinancings and the investment banking side of their houses.

I continue to like BAC and think there is a decent chance that they will make it through without substantial government conversion of preferred shares. Still, BAC does have some risk - potential losses from Countrywide, credit cards, loans and commercial loans remain significant and could outpace earnings. So this is one that has to be watched very carefully, particularly at earnings.

Here's a couple levels I'm watching. Keep in mind that resistance is never a guaranteed floor, only a probably floor.

- GS: some resistance around $127-130; more around $120; it's capital raise was at $120

- MS: resistance looks to be around $26, it's latest capital raise was at $24

- WFC: resistance is around $24, the offering was at $22

- JPM: short term resistance of $34, next level is $32.00-$32.50. JPM is also approaching it's 200-day and 50-day moving averages.

- BAC: no clear resistance level, although $11 looks like a possibility. It's capital raise was at $10.

As for Citi, the government preferred conversion continues to hang over the stock, so don't expect much change until that transaction is executed. I've spoken about USB before, and I continue to like it, but it is a more traditional bank and exposure to credit cards, loans and commercial loans without investment banking revenue to offset pending losses. The same remains true for regional and smaller loan driven banks.

On the commodities side, caution is recommended. Let's start with copper. For a while Freeport McMoran (FCX) was driven by the belief that China might drive growth. Now that consensus opinion sees China's buying as nothing more than stockpiling, copper needs a reason to go higher, and I don't think there's a substantial demand reason to be buying copper.

With natural gas, in the long term it's a buy, but in the short term, huge supply remains, and natural gas prices took a major hit today. I would expect natural gas to correlate with the market in general and the economy; when stocks rise, the market believes the economy has better prospects, and natural gas usage will go up as it's used in homes and in manufacturing. When the market goes down, we obviously have the reverse.

Oil here is tricky. Technically, the chart isn't broken, so it may have more to go. Very possibly this is driven by expectations that demand will increase for the summer driving season. Also, the dollar is sinking. Both of these could continue to drive oil, but expect decent volatility here.

Finally, Treasuries are falling as supply continues to be high, and the Fed today bought less than expected. I missed a buying opportunity Tuesday and Wednesday in the TBT (short Treasuries), which was about $49-50 over the last two days. As we approach the close, the TBT is a little over $52. Longer term I continue to see the TBT as a buy.

I'm long GS, MS, JPM, BAC and natural gas stocks CHK and XTO. I do not hold shares of WFC, FCX and TBT.

The Math on Bank of America (BAC)

So Bank of America has so far sold $13.5 billion of stock. We know that the 825 million shares sold today was at $10 a share, the remainder sold in an ATM offering (at-the-market) over the last week or so, so that was probably at $12-$14.

Bank of America needs to raise $33 billion. So far it has said that it will raise $10 billion through asset sales, $17 billion from stock sales and from conversion of preferred to common, and the remaining $7 billion from earnings. BAC has said that it hopes to avoid converting government preferred to common, meaning that the conversion would come from non-TARP money.

BAC's current share count is 6.403 billion. If we assume that BAC raises the $17 billion from sale of common at $10 per share, then BAC would sell an additional 1.7 billion shares to cover the $17 billion. So the new share count would be 8.1 billion shares.

In 2008, BAC had net income available to common of $4.8 billion and EPS of $0.56. In 2007, net income available to common was $14.8 billion and EPS was $3.35.

Let's use the 2007 number as a proxy for more "normal" times. With $14.8 billion of net income and a share count of 8.1 billion, EPS would be $1.83. With a 11-12x PE in better times, the stock price would be $20.10 - $21.93.

This implies that even with the share dilution, the stock could hit $20 whenever the market stabilizes, the TARP is repaid and earnings are closer to "normal" Of course these are broad approximations, but $14.8 billion revenue of net income is conservative, so there is a fair chance that the stock price would be even higher. Even if that's in 4-5 years, that's a pretty decent return on an $11-12 stock.

So you can see why the market has been so bullish, and why BAC's has been able to raise $13.5 billion through stock sales.

I'm seriously looking at buying some BAC. I'm already long some BAC.

Taking Some Dips: FIG, MA

Tuesday, May 5, 2009 – 3:10 PM

Fortress Investments

So today I took a dip into FIG, Fortress Investment Group. Admittedly I'm a bit later than I want to be, but this thing is moving ridiculously fast. Tomorrow, Fortress has it's earnings call so we'll have a lot more information on how it's doing.

So the thesis on Fortress would be this: if you believe the worst is over, and that Fortress can make money buying assets at a discount, they they should do very well over the next few years, and even the next year.

The stock got hammered because it was a private equity play, and we all know what happened there. It was as low as the $2 range because in january, significant redemptions lowered their assets under management. Mark to market hit their books, and some of their companies had debt problems.

To believe fortress will do well, you have to look favorably on these factors:

1) the redemptions have stopped because the market is no longer staring at a downward spiral.

2) the companies that they've invested in have debt situations that are manageable. We'll get more info on this tomorrow, but in their last earnings call, they said they've taken care of a lot of it.

3) they will be participants in the TALF, meaning they will be buying assets with government backing for a heavy discount. If we assume they're pretty smart guys, they should come out making a profit. Regardless of what happens with the stress tests, these guys should be busy buying assets at a discount.

Fortress is a bit on the speculative side at the moment. Truth be told, earnings tomorrow is a toss up. They could beat, or there could be problems we don’t know about. The argument for beating is that a lot of the market has beat, and similar firm Blackrock is doing really well; the downside is that some other asset managers, like Legg Mason, reported today and didn’t do as well as expected. Still at $6-7, I don’t mind nibbling at FIG and being speculative.


Looking Past the Stress Tests

I still can’t tell you which way the market will go with the stress tests. Everything could be priced in, the market could use it as an excuse to take profits, or the sideline money could come in. In other words, I can’t tell. I’m inclined to think that there won’t be any huge sell off because we know that the stress tests will be positive, and recent buyers won’t have a reason to sell.

So I’m looking past the stress tests, and the only trade I see is being in the survivors, and especially those that will repay the TARP first. That puts Goldman and JP Morgan in front. Goldman, as I’ve said, I definitely like going into the stress tests. I can’t see how they’d come out badly, and the worst case I can see is profit taking. JP Morgan should do well also, and both are in discussions to repay TARP. Jaime Dimon has said discussions will start as soon as the stress test results are released. Morgan Stanley hasn’t said much about paying back the TARP, but there’s been no sign that they need to raise capital, and their fundamentals are fine, other than commercial real estate on their books. Also, Morgan Stanley has broken resistance at $26. On dips, I like all three, but in order, Goldman, JP Morgan, Morgan Stanley. Of couse, I’m watching Wells, BAC, C and USB carefully. I have positions in all except Wells.

There may also be a play in Bank of America if a conversion does not occur. Currently, the possibility of government conversion of preferred is priced in, at least in part, I would argue. If that doesn’t happen, BAC should move.

Mastercard

A few days ago, Mastercard was down as much as $13, from $183 because it lowered full year estimates. Today, it’s back at $183, which tells you how much the market likes mastercard. Put it on your radar screens, buy on any dip. I bought a little at $170, thinking I’d buy a little more if it went down more. Well, it didn’t.

Playing the Secondary Offering

We all know that there will be banks, and other firms raising money over the next several months. For the last year, there has been a play in secondaries. The most familiar case might be Goldman; it raised money at $123 or so around earnings time. For a moment, it drifted down to $120 or so before the secondary, and down to $115 after the secondary. Since then it’s climbed to $135 today. So the simple play is this: the secondary stock offering will drive the price of the stock down because of dilution. Usually, it’s occurred within a day or two of the announcement. The trade is to buy going into, or just after the secondary, because the stock recovers. You can only do this if the successful secondary stock offering is a sign of strength. Meaning that the company isn’t raising money out of weakness. Recently, Northern Trust (NTRS) and US Steel (X) has done the same, and both have a seen a quick rise in the stock after the secondary. Dow Chemical (DOW) just announced a secondary today, I wouldn’t trade that one because it’s coming out of weakness, not strength.

I am long FIG, GS, MS, JPM, C, USB, MA, . Those are my thoughts for the day,

ming

Stress Tests Cause Stress

So now we know the answer to the question, "Where's the pullback?"

It now looks likely that the stress tests could cause some stress, weak pun

intended.  Needless to say, Geithner has handled this badly, but it is what

it is.  We now have a situation where stress test results will be released

over the two weeks.  Apparently, the government will give the banks some

time, probably six months, to raise money.  To improve capital ratios, the

government may convert preferred shares to common, as in the case of Citi.

This could be a major problem for the weaker banks.  As long as there is a

threat of conversion, the weaker banks won't be able to raise capital - who

wants to buy with dilution hanging over their heads?  If the government

converts first, then that will dilute the common and drive down the share

price.  There is a possibility that the weaker banks could raise capital

after conversion of preferred shares, but the stocks of the weaker banks

won't be happy in the meantime.

So I am still researching the following possible trades:

1) buy AAPL on a pullback after earnings.  If more bad news is in the making

I will wait until the bad news clears.  The market is jittery, and any

significant bad news can take the entire market down.

2) GS and/or JPM, probably after release of stress tests.  Difficult to call

timing on this, but the basic idea is that the stress tests could catalyze a

pullback, then it would be time to buy GS or JPM, especially if they could

pay back the TARP.  I will wait on MS and WFC earnings to see where they

stand.  Bank of America has the cloud of conversion over it.

3) If conversion of preferred is likely with BAC, then there could be a play

in the preferred stock, just as there was with Citi.

The Shape of Things

Well, we now have a decent sense of earnings season. Banks did better than expected. Where to from here?

There's not much left in terms of potential surprises. We have Citi reporting tomorrow, and if the last few weeks are an indicator, Citi should do well in its lending and should surprise there. Writedowns remain a question. Also, tomorrow is options expiration, and given the heavy shorting in Citi, there's going to be a lot of short covering pressure. That says Citi should pop tomorrow, but the traders know this, and are getting ready to sell into any pop. For me, not much of a trade, because I can't sell faster than the guys on wall street. The traders will sell seconds into the open after earnings. I think I'll pass.

That leaves Bank of America. Again, they could do well because they have capital markets and lending exposure. Writedowns remain an issue, but if they used purchase accounting with Merrill the way Wells Fargo did, the worst of the Merrill writedowns might be past. That leaves loans, commercial real estate, and credits cards, where losses should be up. JP Morgan confirmed as much today. Still, they may make up for those losses by making money lending and in investment banking, like Wells, JP Morgan and Goldman.

So the question is whether Bank of America's run up to the $10 range is as far as it will go. It could be like JP Morgan today, where today's positive earnings led to negligible movement in the stock; it may have run as far as it can go for now. If you want to be really aggressive, there could be a small play in buying Bank of America ahead of earnings, and selling at the close before earnings. If Citi does well tomorrow, Bank of America could have a small pop, and at $10, small pops could be a decent percentage. Not worth a huge bet, but a possibility if your gambling bones are itching.

And finally, we may have a bit more information when Wells Fargo reports. We'll know about Wells' write offs. But there shouldn't be much new news there, and if anything, downside risk is higher because the quality of earnings could be weaker than expected.

Morgan Stanley also reports next week, but no one expects Morgan to do anything market moving. The best results are out, and Morgan, as mentioned, has commercial real estate exposure that will ding earnings. But that's about it; not as strong as others, but not bad is the expectation. In other words, not much of an event for the market.

After this week, there's not much in terms of upside surprises that are possible. Plus with options expiration, everyone will reposition next week. Right now, I think resistance is around 8,000 on the Dow, 850 or so on the S&P. I've heard people say 900 on the S&P, but every time I look at the charts, 850 seems to be the battleground to me.

The remaining known event that could move the market either way is the stress tests. Given what we know now, which is that the stress tests will tell us which banks are weaker and will give us a capital plan for helping those weaker banks, the release of the stress test results could actually be a positive. That's because we'll have clarity. It's now unlikely that many banks will go to zero, or that the government will let them do so. And a situation like Citi where the government converts its preferred shares to common and massively dilutes the common seems unlikely. The banks that have reported are in decent shape, Morgan Stanley should do fine, Citi's future has already been decided, leaving Bank of America as the last big bank that could face such a fate. There could be pluses in Bank of America's earnings, and there's no indication that it could be a disaster that warrants the government converting its shares from preferred to common.

So consider this additional possibility: the government recently flip-flopped, deciding to release results of the stress tests, where they had previously decided they would be mum about the results. One reason to release the results is that it sets the stage for banks to repay the TARP. As we know, certain banks have been clamoring to do so. If the government gives them the green light post stress test, Goldman and JP Morgan will pop, they're just itching to execute the wire transfer. Wells and Bank of America have had similar rumblings, while Morgan Stanley has said it might be several months. Regardless, if banks start repaying the TARP, the market should pop.

The other possibility is that we could get a sell-off and correction. For the most part, the banks, to date, have held their gains. So that argues for a shallow correction.

Is there a scenario with significant downside? We would need major bad news, which at this point seems unlikely. There is a possibility of a down leg in coming quarters if bank revenues aren't as high but losses continue. At this point, it's a possibility to keep in mind but not necessarily something to bet on.

One other theme. It's time to come back to stock-picking and medium or long-term investing. We are stabilizing, barring any major down legs in the market. The more we settle, the more the trader's market will recede, and the more the longer term investor returns. And yes, it's a great time to buy for the long term.

That's if for today,

Ming

Differentiating Among the Banks for Q1 2009

Tuesday, April 7, 2009 - 1:00 PM PST. This morning, a friend of mine emailed, saying that the market has underestimated how much trouble the banks are in. He wouldn't be alone, of course. Mike Mayo, the esteemed Deutschebank analyst that recently moved to Caylon, came out with a bearish note yesterday on the eleven major banks. The market sold off a bit, but not significantly, so the market seems a bit more optimistic then either my friend or Mike Mayo - at the moment.

I think they are basically right, but it's important to do two things: (1) differentiate among the banks; and (2) separate the trading world from the real, or fundamental world. Yes, those are two different things, I would say.

For now, I'm am dividing the banking world into three groups: (1) the investment bankers - GS and MS, who are technically banks but really aren't lenders; (2) the large-scale commercial banks with an investment banking component; and (3) the traditional lenders.

The Investment Banks. The investment bankers should do well as we approach earnings season. Consider first that most of Goldman's and Morgan's competition is gone, and fees for their services have gone up. These firms have also written down a large portion of their securities, so the FASB mark-to-market changes could actually allow these companies to write-up some of their securities. Worst case, they will probably take the opportunity to reduce additional write-downs. The public-private partners could also help these banks. If the TALF transactions occur at a price higher then their previous marks, theses guys could, again, write-up their assets. Finally, consider that they have low exposure (relative to other banks) to the pending problems in loans, credit cards and commercial real estate loans. Trading-wise, there's less of a case that the market has underestimated the impending losses in GS and MS.

The Commercial/Investment Bank Combinations. Then you have the major banks with an investment banking component, such as JP Morgan, Bank of America, Wells Fargo. The securities side should do well for the reasons mentioned above. And for them, mark-to-market could be of some help. The FASB changes, known as 157-x, apply in June, but banks have the option to enact these changes as of mid-March. Since it takes substantial modeling capabilities to make these changes, it's expected that only the large banks can make those changes in time for Q1 2009 earnings.

Also, these banks have been the beneficiaries of substantial government help. Not only in terms of direct financing, but also through programs such as the agency paper trade. The Fed has bought $250 billion of low-interest-rate mortgages guaranteed by Fannie Mae and Freddie Mac. This has driven up prices of these securities, leading to significant gains for them. Meredith Whitney estimates that total gains might be as much as $5.6 billion, with $1.6 billion for Bank of America and JP Morgan.

For these banks, it's the loan, credit card and commercial loan side that could be a problem. Mike Mayo estimates that on average, loans have only been marked down 98 cents on the dollar. Meredith Whitney estimates that real estate prices will drop 50% peak to trough, while consensus is only 40%. Whichever way you want to dice the numbers, the short story is that there's a long way to go down on the loan side.

So here, for these major banks, the picture is mixed. You have some pluses, and some minuses through earnings seasons.

By the way, Citigroup falls into this category, but it's stock is also in its own category because of an impending conversion of the preferred shares to common. That keeps the stock from moving freely.

The Loan Driven Banks. These banks could will have problems, not only in the next month, but also for the next several quarters. USB is an example: it's a conservative bank with high loan quality, and it avoided a lot of the derivatives investments that got so many other banks in trouble. They're a traditional lender. So while they've been risk adverse, it won't save them from the coming loan problems.

Small and medium size banks will also be at a disadvantage for a couple reasons. Unlike the larger banks, they won't have benefitted as much from government programs. Also, they probably won't apply FASB changes until June. And finally, they're less diversified, and won't have revenue from capital market operations.

The Trading World vs. The Real, Fundamental World. So we have a situation where we could get some positive news for the banks during the first quarter earnings season. And keep in mind, the news has skewed toward capital markets issues that affect the largest, most visible banks. Loan issues have gotten much less airtime, and the banks haven't dealt with these problems as much. That means the short term could be positive (and remember, not as bad as previously thought is positive in this market), while the fundamental, real world trend is probably down.

Trading Implications. I'm still on the sidelines for the moment. Because of all the rule changes and government programs, first quarter earnings may very well be more positive than expected for the banks. I think the greater "danger" area now lies at the end of April, when the results of the government stress tests become known. The Obama administration recently announced that they would wait for the first quarter earnings to be announced before revealing the results of the stress tests. So we have a possible scenario where Q1 earnings might be okay - or even slightly positive, but where end-of-the-month stress tests could throw some icy water on the market. Second quarter could also be a problem as more loans are written down.

All in all, it remains a trader's market. I do think we are more stable, and that is always a plus for the markets. Still, it's not a green light. The next few quarters will be very mixed, sometimes up, sometimes down.

The Rally Expands

Friday, March 27, 2009, 1:18 AM.  So the Dow is up 174.75 today to 7,924.56.  The S&P is up 18.98 to 832.86.  Both the Dow and the S&P are above their 50-day moving averages and are approaching their 100-day moving averages.  

The interesting thing is, the financials didn't really do much today.  The XLF ended at 9.43, pretty much where it started the day.  Financials went sideways, even a little bit down, which in theory is positive for the rally.  That's because you want the financials to hold and consolidate; if the financials go up too fast, they'll just come back down fast.  

The action today was in tech.  The NASDAQ, which closed at 1,587, is actually positive for the year.  At year-end 2008, the NASDAQ was at 1,577.03.  That the current rally has spread from financials to tech is also a bullish sign.  At the very least, the shorts are coming out of tech, and it's very possible that the mutuals funds are buying.  

There are still concerns that this rally is only a bear market rally, and that it's temporary at best. Credit markets haven't really budged, and the bond market is still pricing in a high likelihood of default. Some argue that  the bond market gets it right more often than the equity market does.  

Still, it's very hard to fight the tape, and the optimist would say the bond market is catching up. As a practical matter, I'm going to hold my positions and follow the tape, but be ready to get out if necessary.  And I might even take some profits. I may lose out on some upside, but profits are hard to argue with.  

This next week may make a big difference.  President Obama will meet with the major banks soon.  There's been lots of talk about repaying TARP money, and it's very possible that Obama will ask the banks to hold on to their TARP funds.  Any repayment will favor those that repay, and will stigmatize those that don't.  If Obama asks the banks to hold on to their money, that may force a pullback in Goldman Sachs and Morgan Stanley, two companies that have been vocal about repaying the money. 

Another major event would be a resolution of the mark-to-market issue.  FASB, the board that governs financial accounting standards, is expected to end feedback on it's mark-to-market revisions on April 1st.  Any decision favoring a suspension of mark-t0-market, or any form of relief, would be a huge boon for the banks and the market as a whole.  Of course, it's possible that FASB decides that mark-to-market should remain unchanged, and that the government should relax reserve requirements instead.  That would be huge negative for the markets.  

In the meantime, the markets seem to be favoring the upside. 

One quick follow-up.  Last Friday, I sold the Citigroup that I had purchased for under $2.50, largely because of the impending conversion of government preferred shares to common.  The conversion is expected to significantly dilute the common and keeps downward pressure on the stock.  On Monday, Citigroup shot up to $3.00 or so and I thought I had made a mistake.  Since then, it's fallen to $2.81, while other banks stocks continued to rise.  So with hindsight, it seems to have been a good call.  

The mistake I made last Friday was in Bank of America.  I had bought some for under $6. Not expecting Geithner's plan on Monday, and with the market still wrapped up in the anger over AIG bonuses, I sold my the shares purchased for less than $6 for a little over $6, ending up with a negligible profit.  Today, BAC is at $7.58,  so I missed out on that gain.  Basically, I was thinking that BAC was closer to Citigroup, and the market has since told me otherwise.  That shouldn't really be a surprise, since BAC does not have an immediate preferred-to-common conversion hanging over its head.  Should mark-to-market relief come, BAC should do very well.