This is the second part of The Bubble of Bearishness Bursts. Here is Part 1
To say the fundamentals of banks and institutions have been challenged over the past year is an understatement. The action in the financials has dominated the trading for the entire stock market. In the first five months of 2009, the financial sector and the
traded in the same direction 85% of the time.
Investors have been sucked into a "headline tape," a hysteria-filled environment in which everyone reads the headlines and nobody reads the news. Two popular misperceptions were spread throughout Main Street.
The first misconception was that the Troubled Asset Relief Program was intended as a bailout for every institution that participated. The goal of TARP was to ensure that banks have sufficient capital so that they can continue to lend during a downturn. Since some TARP participants received extraordinary aid, all participants were placed under the same black cloud. (The major banks receiving the most initial TARP funding were
Bank of America
The other misperception centered on "toxic assets." The large majority of losses incurred on collaterized debt obligations and other toxic asset-backed securities were taken in late 2007 and the first half of 2008. These losses were real and depleted the capital base of many financial institutions. As the recession and crisis deepened, the concern over "toxic assets" escalated.
Banks did still hold some CDO positions, but any position a bank originated prior to 2008 was a bad position because of the environment. The problem was that the word "toxic" was being applied broadly to all assets, as if they were all as risky as CDOs.
Because credit standards were extremely lax from 2005 to 2008 and we are in the midst of one of the worst recessions in recent history, there will be some significant credit defaults. At this point, however, the majority of defaults are with respect to assets that one expects a bank to own, but no one has taken the time to evaluate the actual types of assets instead the term "toxic" is broadly applied.
Imagine that someone was reviewing your household balance sheet. Whether it is your brokerage account or your 401(k), he or she would see that you were down 38% in 2008 but would not know your actual investments.
The natural reaction would be that you own something very "toxic," when in fact, you simply owned the S&P 500, which most investors are expected and even encouraged to own. Your problem is that you own it in a very bad environment. So, we wound up with an environment in which financial institutions were significantly penalized by the market for owning exactly what they are expected to own. They simply owned these investments in a deteriorating environment.
Fear, the "headline tape" and misguided calls for nationalization fueled the negativity on top of legitimately bad fundamentals, which created the perfect storm for the bubble of bearishness. The price action only fueled the hysteria. The more stocks went down, the greater the conviction for nationalization.
As a result, buyers almost entirely retrenched throughout the market and stepped away. Bears were shorting into a one-sided tape with only sellers and no buyers. If the banks were going to survive, then valuations for a long-term investor were actually compelling. The key word was "if."
So we were on the brink of whether banks would or could be nationalized. In reality, nationalization would have nearly destroyed almost every insurance company, pension fund, endowment and retirement plan in the nation.
Consider your losses in the market and multiply them by two. Furthermore, the outcome of nationalization was unknown, and recent government interventions did not bode well.
were under Uncle Sam's stewardship for six months with no success.
Nationalization would have been the worst pro-cyclical response to a crisis in history. We are all lucky that Ben Bernanke took Milton Friedman at his word and believed that more effort should have been made to save the banks during the Great Depression. Instead of nationalizing, the government effectively nationalized the banks' risks without wiping out the equity owners or impairing the creditors.
When economists think of the traditional ways to respond to crises by wiping out equity holders, they fail to recognize two things. First, in a systemic risk situation, the priority is to halt the domino effect of the panic. Second, the landscape of the investor class has changed dramatically over the last three decades.
In 1980, 6% of households owned mutual funds, today, 45% do. In 1980, 3% of household assets were held at investment companies; today, it is 19% (that is where our savings rate went).
Nationalization would not have halted the domino effect of the banking system collapse, it would have hastened it. In addition, it would have further damaged the consumer and the American public. The
and Treasury wisely recognized (thank you, Milton Friedman) that there were more options than the "traditional way" to respond to a systemic event.
The market began to rebound when the Fed chairman testified in front of Congress that the banking system would not be nationalized and that they would not shut down any major institutions. Those investors who had shorted into a market with no buyers were now forced to buy into a market with no sellers. By the time the stress test results were released in early May, the rally in the financial sector was more than 120%.
This gave the banks an opportunity to raise tremendous amounts of capital at prices close to their highest share prices for 2009. The rally was not only in equities, but also in various forms of credit, including credit instruments with bad fundamentals. Just like equities, these instruments were shorted as well. Although we will not know until earnings are released, companies should have taken advantage of the credit rally to reduce and hedge their legacy credit exposures.
While it would certainly be a stretch to describe financial institutions as "healthy" today, they are far healthier than they were four months ago. They are also far healthier today than anyone would have expected them to be four months ago.
Essentially, the fundamentals or the perception of the fundamentals became so bad that they kick-started that self-correcting process that we saw in the markets. The upshot of all of this is that yes, the fundamentals matter, but it is the future fundamentals that matter. So when oil companies have taken a tremendous number of rigs out of the ground, that sets up a bullish dynamic for the future. If homebuilders have no inventory, that too sets up a bullish dynamic for the future.
Too often, too much focus is paid to coincident or even lagging indicators, such as unemployment. If you want a good timing indicator, sell the market when the unemployment rate is low and buy the market when the unemployment rate is high. That is the type of action that sets an investor up for the future fundamentals. If investors focus upon the future fundamentals, they will not get trapped in the "headline tape" of coincident fundamentals or a bubble of bearishness
Mike O'Rourke is chief market strategist for BTIG, where he advises the firm's clients on Market developments and provides them with "Market Intelligence." Mike's primary focus is identifying short-term catalysts driving daily trading activity and addressing how they fit into the "big picture." O'Rourke has 13 years of experience in the financial markets. He started his career on the floor of the New York Stock Exchange with specialist firm Spear, Leeds and Kellogg. At SLK, Mike transitioned to the Nasdaq as market maker trading technology stocks in the late 1990s. In 1998, he joined the Proprietary Trading Group, managing his own portfolio, and thereafter, he traded proprietarily for Goldman Sachs following its acquisition of SLK. In 2003, he joined one of BTIG's predecessor firms. In 2006, O'rourke was appointed as chief market strategist for BTIG.