Agora Financial’s Rude Awakening

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Dubai, UAE

• Dow steadies but sells off again in Europe overnight,
• Equity’s disappearing act and the long, hard slog that follows,
• The final day to grab your short selling opportunity and more…   

Joel Bowman, reporting from Dubai in the Persian Gulf…

“There’s a reason this food is so cheap,” we moaned yesterday, tossing the remains of our takeaway lunch into the trash. “The bread is soggy, the sauce is disgusting, the whole sub is full of withered lettuce…and where’s the bloody meat?!”

Standing there in the scorching midday heat, while passersby laughed as our limp bun surrendered its contents to the sidewalk, we once again became acutely aware of the old adage “you get what you pay for.”

Had your editor made the effort to walk down the block a few stores to one of the gourmet eateries or, dare we say, taken the time to make his own lunch, he may have been spared this unpleasant experience.

Still, it’s better to learn life’s big lessons when the stakes are small. There will be other opportunities to buy a better sandwich, in other words.

The same cannot easily be said for all the would-be rescuers who piled into the smorgasbord of destitute financial stocks earlier this year. Eager knife-catchers have watched their bargain basement investments in U.S. financial institutions fall through every declared floor, perusing lower highs and still lower lows.

Now, it appears they are losing their appetite. 

But first, the numbers…

The market took a breather from a two-day beat-down yesterday, regaining its wobbly stance to finish up around 68 points. Investors cut and run from the financials in droves on Monday and Tuesday to leave the beleaguered sector down almost six and a half percent and bleeding from one eye.

We can’t blame investors’ eagerness in heading for the door. It must be difficult to maintain a rosy outlook when even the banks themselves are writing each other down.

And the melee didn’t stop while Wall Street slept either.

In Germany, Citigroup Inc. reduced its earnings estimates for Lehman Brothers after the Financial Times reported that Korea Development Bank and China’s Citic Securities Co. abandoned talks to buy a stake in the fourth-largest U.S. securities firm. Apparently foreign capital providers are still reeling from indigestion after their last foray into the embattled US banking sector.

Citigroup analyst, Prashant Bhatia, also slashed his earnings expectations for Goldman Sachs Inc. and Morgan Stanley. Then, in a predictable tit-for-tat, Lehman lowered its quantifiable public opinion of both Morgan and Goldman.

Overnight, traders in Europe took this as their cue to resume selling. Combined with the expectation of higher oil prices in the pipeline and sluggish outlook for airlines and retailers, futures on every major US index fell in London.

How will things shape up back on Wall Street? We reckon that largely depends on investors’ tolerance for financial salmonella.

In today’s column, Eric offers some more thoughts on the emerging “Age of Caution” that invariably follows such a prolonged period of binge buying. What follows is a lightly edited version of the presentation Mr. Fry gave at the Agora Financial Investment Symposium in Vancouver a couple of months back. [If you missed it, you can catch Part I here.] Continued below…

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The End of Peak Greed, Part II
By Eric J. Fry

What’s an investor to do in this nascent Era of Caution?

Sell risk; buy caution. Sell complexity; buy simplicity. Sell the beneficiaries of discretionary spending; buy the beneficiaries of necessary spending.

Every once in a while at the Rude Awakening, we conduct interactive investment exercises with our readers. We call these exercises, “Group Research Projects.” We ask readers to submit some ideas and then we publish them. Some of the projects have worked out well. Others haven’t worked out so well. I’d like to mention one of them that worked out quite well.

[About two years ago], we asked readers for “housing bust pair trades.” The title of one of the resulting columns was “But Spam, Sell Frappuccinos.” The exact idea presented in this column was to buy Hormel [NYSE: HRL] and to sell Starbucks [Nasdaq: SBUX]. In that same column we suggested selling Countrywide Financial and buying California Water Services. Both of those theoretical trades worked out well. They both performed as expected, given the bust that ensued.

I like to think conceptually like this, in order to formulate ideas about how we should be investing. So I’d like to suggest a few potential pair trades. These are just some general ideas – either from colleagues or from the cab driver.

On the sell side of the equation, I would strongly urge avoiding financials, or at least minimizing your exposure to them. As Chris Mayer pointed out last year, “The early bird gets the worm, but the second mouse gets the cheese.” That’s a great line.

But I’m thinking, you’re probably better off not being a bird or a mouse at all. It’s better to be a killer whale. It’s better to be a carnivore that’s an opportunistic feeder. It seems as though anyone who has tried to be a mouse in the financial sector has had their head handed to them. During the last twelve months, how many times has the “smart money” gone in and tried to buy into the financial sector?

There’s a long list of victims here with self-inflicted wounds. Bank of America was one of the first ones. It spent $2 billion to buy part of Countrywide; Abu Dhabi spent money last November to buy into Citigroup; Warburg Pincus spent money to buy into MBIA; TPG bought into Washington Mutual…and that was as recently as April.

And at the same time, you have people like Bill Miller, the once-idolized manager of Legg Mason Value Trust [LMVTX], who had a remarkable investment record for a long period of time. But he’s been averaging down in the financial sector like an odd-lot trader. He has been buying and buying and
buying and buying…all the way down, all the while bleeding assets. He only added to eleven of his largest positions during the first quarter. And eight were financials. And this is while he’s bleeding off assets. This is a strategy that illustrates genius in a bull market.

But in an Era of Caution, I would submit that that’s not genius. It’s not genius yet, anyway. You know, we’ve all heard the adage that you’re supposed to buy when there’s blood in the streets, but it’s not supposed to be your own blood that’s in the streets; it’s supposed to be someone else’s.

This is a bit of an aside…but some of my colleagues and I attended the Value Investing Congress in Pasadena in April and one of Bill Miller’s colleagues gave a presentation. The guy was full of hubris and confidence…and he referred to the credit crisis in the past tense. “We got in there. We were buying these [financials] in March…and we did this and we did that,” and he went on and on and on about what a genius he was. But he let slip a line that was something like, “If you think that this isn’t a good buying opportunity, you really don’t know what you’re talking about. Look, Bill Miller is not going to be brain-dead forever.” I don’t think he meant to say that, exactly like that, and I certainly hope that Miller won’t be.

In April, Secretary Paulson took his turn calling the bottom in the financial sector. Here’s what he had to say:

But recent dismal results from the financial sector show us still that the bottom may not be in. Almost no one can buy a house these days. But almost everyone is eager to buy the shares of the companies that can’t sell the houses that nobody can buy. And I think that’s about all you need to know about the financial sector and the housing sector to know that we’re probably not at the bottom yet.

These financial stocks will be a buy one day, there’s no question about it. And maybe they are right now. I am not arrogant enough to say that I know. I mean, maybe this is the greatest buying opportunity of all time in the finance sector. It could be. And I mean that genuinely. But I don’t believe it is.

Any investor who is tempted to bottom-fish in the financial sector, should take a look at this chart:

It compares the Nikkei Index to the Topix Japanese Banking Index. You can see that the Topix Banking Index is down 80% from its high in 1989. That’s a very, very long time. Not only that, the index rallied around 40% to 60% seven times during that period. Seven different times investors believed that this index was recovering. And seven times, it did not.

One of the reasons is that during a period of de-leveraging, such as Japan suffered, equity disappears. Equity struggles. A lot of good things can happen to businesses; a lot of good things can happen to individuals; credit can flow again. It doesn’t mean equity is going to recover. Equity suffers. It goes away.

These things will be a buy someday. It’s just that I prefer to miss the first 20% of the upside. And I’d rather buy into something where I can see at least a sign of a rebound. So why not invest in the companies that are making the world go around, and are performing well, instead of the companies that are making the world go into a tailspin?

To be continued…

[Joel's Note: Are you getting that kind of “calm-before-the-storm” feeling too? Gold is on the march again, the housing report from earlier in the week gave the permabulls a good lashing and the Freddie and Fannie house of cards looks set to blow over any week now. All that and the much-celebrated market rally from earlier in the month has virtually whittled away to nothing. After all the cheerleading, the Dow is barely up 100 points since August 1.

“Doing nothing,” as Eric explained in yesterday’s column, might prove the prudent move during this ongoing period of de-leveraging. And, as your editor’s girlfriend constantly reminds him, we harbor a unique acumen for achieving sustained periods of “doing nothing.”

But if you really must “do something,” perhaps adopting a sound short strategy might be in order. To help you get started, we’ve cobbled together a “first three months free” offer to Dan Amoss’ Strategic Short Report. The catch here (isn’t there always a catch?) is that this offer expires tonight. If you would like to jump on board at the discounted rate, now’s your chance to do something about it. Click here for more information: Strategic Short Report: 3 Months Free

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[Rude Endnote: Finally, the long-awaited release of I.O.U.S.A. is tonight. If you haven’t got any plans for the evening – or if your existing plans involve the in-laws and/or your mate’s holiday slideshow – grab a ticket here and get your bum on a theater seat near you.

Until tomorrow…

Cheers,

Joel Bowman
Rude Awakening

aussiejoel@the-rude-awakening.com