Stop Taking Risks Bottom-Fishing in Financials

IN JUST SIX SHORT weeks since it hit a bottom on July 15, the financial sector of the S&P 500 is up a scorching 24.3%. I told you then, when the drama of a possible collapse of Fannie Mae (FNM) and Freddie Mac (FRE) first started to unfold, that this was all much ado about nothing.

Even as the overall sector recovers, the drama of the two GSEs continues. Just one week ago, Fannie and Freddie hit new lows. Nevertheless, it seems as if the world has come around to the view that I expressed in July: that the GSEs are going to survive. Both stocks have doubled from the bottoms they hit on Thursday of last week.

A speculator's dream? Perhaps. But I think that the financial sector is an investor's nightmare. Try to catch the precise bottoms if you can. But how many of us are that lucky or that skillful?

On Aug. 1, I laid out a case for why the financials were no bargain -- even though I'm confident they aren't going to zero. At that point, the sector was up 25.7% from the July bottom. Alert readers, who compare that number to the one I cited in the first paragraph, will draw the correct conclusion that the sector has actually lost money for investors since Aug. 1 -- 1.1%, to be precise.

So timing is everything. Which means it's all about speculation, and not about investing. Don't get me wrong -- there's nothing wrong with speculation. It's a noble calling. I speculate quite a bit myself. But let's not confuse it with investing.

In this market there are lots of better ways to invest than trying to get lucky with financials. I'll get to my favorite investment idea in a moment, but first I'd like to lay to rest any ideas that investors are harboring about buying the financial sector for the long term.

First, let me reiterate that I don't think the financial sector is going to go to zero, as so many investors seem to fear. Second, when the wave of fear that's now engulfing the market dissipates, I have no doubt that the embattled financial sector will have a good upside run. My point is that long-term -- and I'm talking about, say, over the next 12 months -- I think it's very unlikely that the sector will be a top performer.

Many of my institutional clients, however, believe that financials will be a top performer. They remember the spectacular long-term run that the sector had coming out of the savings and loan crisis in the early 1990s. In some ways, it's a good comparison: There certainly is a crisis now, and, just as in the earlier episode, we will indeed come out of it. But other than that, the comparison doesn't match up.

Once the S&L crisis was dealt with, the financial sector grew to be the largest sector in the S&P 500 -- in terms of the number of companies, total market cap and earnings. Thanks to the current crisis, it still has the largest number of names -- but it has lost the other two distinctions.

The financial sector's success coming out of the S&L crisis was due to the convergence of four very powerful megatrends: consolidation, automation, globalization and securitization.

Financial firms were able to grow earnings and achieve efficiencies by acquiring smaller rivals. They were able to improve margins by exploiting the inexpensive computer and networking power that suddenly became available. They achieved economies of scale by expanding globally. And they profited from new methods of bundling up traditional loan products into easily-traded securities.

So after all that, what do you do for an encore? At this point, consolidation won't be about achieving efficiencies -- it will be about survival. Automation? Been there, done that. Globalization? Ditto. And securitization? That process is going to run in reverse, with sophisticated new ways of packaging products reverting back to the clunky old ways of the past -- because the complexities and opacity of securitization have been blamed for the subprime loan fiasco.

So what, exactly, is the financial sector supposed to do for earnings growth?

I can tell you it's not going to be subprime lending. A couple years ago, when this sector was on top of the world and capable of doing anything it wanted, subprime lending was what they chose to do. That was their best idea: Lending money to people who couldn't pay it back.

So again -- what, exactly, is the financial sector supposed to do for earnings growth? Nothing. There won't be anything for them to do. Oh, sure, there will be reported growth once all the write-offs finally stop. But that's not really growth. It’s a one-time catch-up effect, and it says nothing about the actual growth power of these businesses.

There's no value case for the financials, either. Even using forward consensus earnings, which look beyond this year's write-offs, the sector has a higher price/earnings ratio today than it did a year ago before the crisis struck.

Here's a better idea. The basic materials sector -- metals, chemicals, fertilizer, paper and so on -- is up only 0.9% since its July 15 bottom. It's been the second-worst-performing sector in the S&P 500 so far during the recovery. Only the energy sector has done worse, as the price of oil has collapsed.

In fact, I think the sharp drop in oil prices is to blame for dragging down other commodities prices, and for putting pressure on materials sector stocks. I also think oil prices have further to fall, or at least it's highly unlikely that they will rally back to the July highs -- that was a speculative bubble that won't be easy to put back together now that it's popped. But I believe the prices of other commodities -- gold, foodstuffs, copper, etc. -- have substantial room to rally. And that will bring back the depressed materials stocks.

Commodities are driven by two things -- demand growth and inflation -- both of which are alive and well. Yet, right now the conventional wisdom doesn't believe that.

Everyone says we're in a recession. We're not. Demand growth for commodities is very much alive. If you doubt it, re-read my column from last week. If that doesn't convince you, open up the newspapers and read about last quarter's 3.3% real GDP growth. If this is a recession, bring it on. In fact, let's have a depression!

And, just because the oil price has dropped from all-time highs at $147, everyone says inflation is not a problem. Well, let me tell you that an oil price of $115 isn't exactly deflationary. Sure, it's better than $147. But just a couple short months ago, $115 was an all-time high, too.

Meanwhile, the Fed is as loose as a goose. With the fed funds rate at 2%, that's about 3.5% below the prevailing inflation rate. That means, after inflation, the Fed is paying you to borrow money. If that isn't a recipe for inflation, I don't know what is.

The bottom line is: Stop taking crazy risks bottom-fishing in the financial sector. It's already made a huge move off the bottom. And just because it's not going to zero doesn’t mean it's going to perform well as an intermediate-term investment. Instead, invest in the basic materials sector, the sector that hasn't moved at all since the bottom, and that has all the fundamentals aligned for superior intermediate-term performance.

Also See:
The Worst Recession Since the Depression? No Way
Today's Investor Sentiment Makes No Sense
Merrill Move May Mark Capitulation on Financials