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Don Coxe
May 26, 2004
Chicago
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Thank you and thank you all for tuning in to the call which comes to you from Chicago. The reason for having it today is because I'll be traveling, I'll be on the road in various locations in Canada over the next three weeks.
The chart that we faxed out was the Philadelphia Stock Exchange bank stock index, which is the Keith ___ Woods index. Because of the proliferation of closed end bond funds and other things, the New York Stock Exchange financial index which is the one that I used for a long, long time ceased to function, so this is the best one we've got for doing a discussion of the outlook for financial stocks.
I want to cover this topic and then I'll touch on some other things that have occurred in the past week.
Those of you who have read the current Basic Points will know that I've made a very significant change in my attitude to the group, which has been overweight for three years. And I've gone to a neutral position. So I want to explain the background to that and also to give you some sense as to what I see are the risks and rewards in the group because for most investors this is really where they start in looking at the stock market.
The financials have become a bigger and bigger and bigger component if indices. Used to be that there were very few banks that were listed on exchanges in the United States and even abroad there were very few. And one of the things that's happened over the past few decades is that banks have gotten themselves listed and state owned banks became privatized so that globally what you have is a huge weighting in this group. Plus the fact that the last twenty years have seen a huge expansion in the kind of market and the kind of range of services that are available in stocks that you can buy in.
You couldn't didn't used to be able to invest in money management firms, for example and now there's a huge number of those available and then you have such extraordinary things as Fannie Mae and Freddie Mac. So in talking about the financials, you start with the fact that the generalizations that you used to be able to market about them are somewhat dangerous now because if you go from a fire & casualty company to a specialist writer of particular kinds of risks to a life company and then with a life company those that are diversified financial services companies. Then going in to what used to be the brokers, which became investment banks and then among the banks, in this country we are still going through the process of consolidation from the tens of thousands of banks that used to exist to a more manageable number.
The last state that will really get consolidated is the state that is my adopted home, Illinois. Twenty years ago, it was illegal for a bank to in this state, to have more than one branch, which is the key to why Continental Illinois collapsed. And we're actually holding this call on what is as close as I could get to the twentieth anniversary of the collapse of Continental Illinois, which was a landmark event. It turned out to be one of the greatest financial crises, since the collapse of 1929.
Because Continental Illinois had become the seventh biggest bank in the US, by bulking up and getting Eurodollar deposits to make up for the fact that of course they couldn't attract local deposits because they couldn't expand. And when the holders of those Eurodollar deposits which were mostly foreign banks and investors saw the terrible job that Continental was doing particularly in their oil lending and the collapse of the oil industry, they declined to roll over their deposits and precipitated a sudden, like twenty four hour collapse of the seventh biggest US bank.
Now this is one I had a chance to study at the US taxpayers expense for two weeks back in the fall of '84, I was listed as a distinguished visitor and I had a chance to interview the officials involved. That was a full blown crisis. The TED spread went to its all time high of 400 that morning. Just amazing. So, that's history.
But now we still have about 800 banks in Illinois and that's one of the reasons why the bank that I toil for, the Harris Bank, is able to keep growing so effectively because it can keep buying up small attractive banking properties and growing by acquiring at not unreasonable cost.
So when we talk about the financials then, we're talking about a wide range. But there's no question that in terms of the growth of the banking industry and to a certain extent the financial industry, a big, big force has been the huge expansion of mortgages. So therefore the other reason why I chose this week for it is because this is another event. We're up 100 basis points now in yield from the lows on the 30-year mortgage year over year. And that's a significant move, obviously, because what it means is that mortgage re-financing is plummeting. And therefore a big source of income from organizations like Countrywide Financial and retail banking operations is going to be shrinking.
As long as they're having a continued drop in interest rates and mortgages down here have priced off the 10-year Treasury note, people could - because in this country you can re-finance at any time - without notice and with tiny bonuses for doing it, it meant that there was a one way optionality which is the key to the mortgage-backed financing product, which Fannie Mae and Freddie Mac peddle. So, now that we're not having a flood of re-financings, the duration of the mortgage-backed sector is climbing. It's up from a low of half a year to three and three quarters years and it continues to climb.
In the current Basic Points, I address the question as to whether we could be seeing another crisis coming, this time in the mortgage-backed sector. And if we did, we're not talking about a small sell-off in the financials or a small sell-off in the stock market because the mortgage-backed sector is now up from 16% to 36% in the index. 16% was in 1994 and it was the collapse of mortgage-backeds which was the key to that horrible bond market and the sometimes scary stock market of '94. The stock market basically broke even because the economy was doing so well.
Now for the last three years I've had what has seemed to be a contradictory stance which is recommending the commodity stocks and recommending the financials. And I guess I've had more calls and e-mails and questions about this than any other single call that I've made in that time, because people have sought to find out what the logic was. How could you be recommending organizations which seem to get rich with interest rates falling and be recommending commodities? Well oddly enough, that has worked out pretty well. Until quite recently.
And the reason for that is because the range of derivatives available allows organizations to hedge their risks. And if they do it well it works out well. If they do it badly then that company's in trouble, it doesn't mean that the system is necessarily in trouble. But, the other reason for it is because I'm strongly of the view that in this decade, total return is going to come back as a concept in investing in equities. And this is the pre-eminent growth total return group. Because the utilities, the regulated utilities, how many of them there are I'm not sure are just plain not growth industries. And those that try to become growth industries, a lot of them went bankrupt. So the ones that make very good sense for investors, to give them rises in income year after year are basically the financial stocks, headed up by the banks.
And then when President Bush came out, once again, exactly a year ago with the announcement that the new dividend tax treatment would be accorded to foreign companies that are listed here as long as they were headquartered in a country that had a tax treaty with the US, what we had was a huge amount of money flowing in to the Canadian bank stocks.
It was last year's Victoria Day, when Canadian markets were closed, that the announcement came out over the weekend confirming that interpretation of the new law. Which meant that when I was in my office on Victoria Day, although it was a terrible day for the stock market, for totally different reasons, of the nine stocks on my screen that were green, five were gold stocks and the other four were inter-listed Canadian bank stocks, two of which went to new highs. Because - and it still is true - a US investor in the higher tax bracket that is, somebody with over $200,000 of income, gets anywhere from three to four times after-tax income out of owning a Canadian bank stock down here as opposed to a money market mutual fund.
And in addition, the Canadian banks and the financials generally have a good record for raising their dividends faster than the rate of inflation. And so it's been my view that as people move away from the now-antiquated concept that you own stocks up until the day you retire and then you put your money into bonds, that is clearly a bad strategy when we're in the early phases of a bond bear market. You don't want to commit yourself that's going to go down only in price.
So I've argued that the good financial stocks, the ones with the great dividend records and where you can see a commitment from management to growing the dividend faster than inflation, they're better than TIPS. They have a much better yield than TIPS and in addition, they grow faster than the rate of inflation whereas TIPS just grow at the rate of inflation.
So why have I gone to a neutral weighting, despite this? Well, the single biggest reason is because of the strength of the Kerry candidacy, which is really to say the weakness of Bush's political position. Because Kerry has promised that he's going to repeal that provision that Bush got through along with other tax breaks for the rich. I guess when your family is worth $590 million, as Kerry is, and you have eight cars and five homes, you're not too concerned about what the after-tax yield is on your stocks.
So what we have then is a situation where one of the major arguments that I've been using for people to buy these stocks is now called into serious question. Secondly, there is concern beginning to develop, and I share that, that the proliferation of second and third mortgage products which are held in the banking system overwhelmingly means that when not if housing prices start to retreat that we could see some problems in the system, for those that were doing a lot of the sub-prime lending.
The third reason is that the financials are such a huge weight now in the indices, more than a third of the weight of the Russell Value index and over 21% of the S&P and in Canada more than one third of the weight - what we've got is a situation where if the stock market is having trouble, then this is a group that everybody owns and is a logical source of cash.
Finally, the reasoning is this. There's an excellent forecasting record for this group. When this group has a sustained negative performance relative to the S&P, it usually signals a bearish market condition. It can be one of the various varieties of bears that I've written about in the book. But when they are outperforming the market we have a bull market and that's a very safe prediction. So it's one of my most reliable indicators for the stock market itself. And since I have a rather low weighting in equities in my recommended asset mix, then my overweight position in the financials was a contradiction to the position I was taking and the reason I was doing it was because of those special factors.
Now, having said that, because the group is so heterogenous, there remain attractive groups within it. And so what I want to quickly discuss is which ones that I recommend that you hold or or look to buy if we do have a sell-off. I remain bullish on the Canadian bank stocks because for an American investor, you'll be getting a growth in after-tax income in a currency that's rising in value. And I believe that will continue, notwithstanding the pullback we've had in the Canadian dollar. That's a very attractive asset.
No, I'm not a believer in the merger of the banks, the Canadian banks. I've never believed in that. Because it's got to be decided by the politicians and there's nothing in it for the politicians. Certainly my colleagues in the organization, many of them disagree strongly on this, I'm just telling you my personal view which is that I start out having had such a background in political analysis, saying that something that does not have broad support among the public at large and in particular, does not have good support among the small business community has political problems. Notwithstanding the powerful arguments as to why it should be done.
And so, what is being relied upon is for the politicians to do the right thing. And politicians will do the right thing if they also see political advantage. If they don't see political advantage then it requires an extraordinary level of political courage. And so, I'm not one who in my career has liked to make bets on an extraordinary level of political courage. So notwithstanding the powerful logical arguments why Canadian banks should be allowed to merge, I've just been a skeptic that politicians will come around to it. It's basically a political call.
So my argument for them has not been on the basis that there's going to be a capital gain because of a merger. If that happens, that's great, but that's not the primary reason to do it because you're taking a bet on an unknowable. The reason for doing it is because these are extraordinarily well-managed institutions and they have this dividend record. And Canada has the superb banks compared to banks elsewhere in the world. So on that basis they're just plain great investments that fit into the category of what you should own this decade.
As far as the US banks are concerned, I'll do something that I rarely do, which is to tell you which is my favorite stock by far in the group and it's BankAmerica. And the reason for that is because BankAmerica is unique among large banks in this country or maybe in the world. It does not have Eurodollar liability. They fund themselves with retail deposits. An amazing accomplishment.
Now they learned because they got into serious trouble in the 1980's, during the various banking crises then. So therefore I believe that BankAmerica is much, much stronger than its competitors in this country and therefore that it's entitled to a premium multiple. The stock is basically flat this year and part of that was because, like so many others, they'd bought a mutual fund company which turned out to have some bad apples in it and that was bad publicity for them.
But notwithstanding that I think that's extremely attractive for those who want to own a bank stocks in this country. As to the big investment banks, the one that's gotten hurt the most recently is Goldman Sachs and part of that reason is because there's a perceived Asian play within the stock and therefore in a funny kind of way it's behaved like a commodity stock. That when the bad news came out of China people saw that one of the potential area of growth for Goldman was cut back. Plus the fact that Goldman is the pre-eminent trading institution maybe in the whole world and the market has some difficulty figuring out how much money to assign to trading profits particularly if they're worried about a big run-up in bond yields.
So it sort of stands alone. But if you look at the others that are tied very considerably to growth in brokerage revenues and to individual products, you can certainly make cases for owning some of them.
The group that I guess I'm most attracted to is the fire and casualty group because they've been able to put through huge premium increases and the caveat though is that we're getting more and more announcements that there may be a full-blown terrorist attack timed to defeat George Bush. And what we learned from the twin towers litigation was that insurance, the owner of a building can be held liable for failing to make it strong enough to withstand a crash by an airliner fully loaded with gasoline. I guess even in my wildest dreams about tort law in this country I wouldn't have thought the landowner had to plan for that, but that's the way it worked.
So therefore, those who are insuring office towers may have some special risk, but that's sort of too macabre to talk about.
Put it all together and I believe that you should stay with the group. In Canada you've got some of these wonderful insurance companies. They have such a huge weight there particularly Manulife, that it's very different from the market I work in where the overall weight isn't as significant. And there what you have is great companies, well managed and they're able to make good acquisitions. And of course the strength of the Canadian dollar has meant that their currency, the value of their stock is so much better. That probably was one of the big factors in the ability to take out John Hancock.
So that's my view on the group, that it's so heterogeneous that you've got to use stock picking within it, but you've got to own exposure to the group if you're in the stock market at all.
Finally, as regards the other themes, the news from Iraq continues to be disappointing. Bush's approval rating continues to fall. And this is something that I think is going to weigh on the stock market. It's not that all investors are Republicans. But if what's driving his approval ratings down is the sense that the US has lost its way and is involved in a major international disaster, that affects Americans view of themselves and of its mission in the world and that tends to make them less willing to make long term commitments. So it does have an impact on the market at large, Democrats and Republicans alike.
Maybe the news is going to turn better after June 30th, when they have the handover. The other possibility is they'll go into a full-blown civil war. Who knows? Too difficult to make that call. What it does suggest is that we've got problems for the stock market, notwithstanding economic news. So I think you're going to see more of the same kind of trading that we've seen, which is that you have one good up day but then you're going to have lots of selling creeping in.
But the viewpoint I took in Basic Points was we could well be in a situation where by mid-summer, we'd have gotten confirmation that China was managing its slowdown effectively and that the Fed was managing its tightening process well by having given signals in advance. If that happens, and news from Iraq isn't horrendous, it's just bad, what we could have is a very powerful rally going into the election. Because ordinarily, stocks go up in election years.
So therefore what I'm saying is that I think this could be a summer where those who are out of touch with the market could miss a major flex point. So I remain bullish that you should own the commodity oriented stocks, lead of course by the oils. If you just simply look at the weighting of the oils within the commodity group, you're automatically going to be overweighted in that group, within the group. And I still think that these stocks are incredibly cheap relative to the rest of the market. So, therefore the only significant change I'm making in my investment stance is the reduction of the financials from overweight to neutral. And that is the story, are there any questions?
Steven B: Materials…the worst performing sector this year. Seems to be about the China play. I mean we got in early enough to where we’re watching our profits erode this year and we’re not terribly worried about the unwinding of the leverage there, but going into what seems to be a mid-point in the economic cycle so we’re not really talking about recovery anymore, we’ve got a full-blown expansion taking place.
And looking towards the latter half of the economic cycle, typically investment strategy would be shifting to the more defensive and less cyclical or the non-cyclicals which we’ve seen some leadership in staples and we’ve seen some very good growth in value fundamentals and healthcase.
So that the non-cyclical leadership seems to be logically the place to be but as you’ve pointed out ad nauseum, this cyclical environment for materials is really different this time. Is it all about the China play and if China does have a hard landing are we going to see our long positions in materials get hit further?
Don Coxe: Well thank you. One of the reasons, one of the things that ordinarily happens in this stage of the cycle with these is that you start seeing expansion of inventories and you start seeing big contangos developing in the commodities because people start to see squeezes out there and they respond to them. What we haven’t done is seen that. What we still have is severe backwardation which means that the producers of things are doing more selling than speculators are doing buying and inventories continue to be very slender.
So, now admittedly with the US recovery, the only material that really matters that big to it is the hydrocarbons. And so we’ll put that aside as to whether the US economic performance is that crucial. There’s no doubt that portfolio managers and this is now the new received wisdom on Wall Street, we’re far enough along in the cycle that you get out of the deep cyclicals and go in to the more defensive stocks.
And that’s the way you would have played it in previous cycles because what you could say is there were signs of speculation within the commodities and that that was the sign of a near term peak. And as long as the world economy was driven by the American consumer virtually alone, that was a good way to play it.
So the question is whether China and India with their voracious requirements mean that this cycle will behave very differently and in fact it will be the first of the cycles for this new millennium which will behave differently.
It’s always difficult to convince people when they’ve seen a pattern that’s worked cycle after cycle after cycle that there should be a change. But, for example, we saw that with the heavy industrial stocks in the US when it turned out Japan was eating their lunch. And these stocks just did not follow through then, in the 70’s and the ‘80’s because there was a change, an Asian force in the market which meant that these companies were having all sorts of problems. They couldn’t just rely on growth in internal demand, they were faced with this new competition.
So I would argue that, Steven, what we’ve got is that kind of Asian differential in the materials, where, I mean, last year, you know, US demand for copper fell 2.6% and copper prices were up 80% year over year. But there are still lots of people whose research I see saying “Oh no, that just indicates how much overvalued copper is”. So they are still using US and European consumption numbers and saying the party’s getting late, let’s exit.
So, those people who did get excited about the China story dumped the China stocks as soon as we had Avian flu announced and then talk of SARS and then talk of a crash. So therefore the thing that was sustaining buying from a different group of buyers got wiped out because of the fear that buyers who were really pricing these commodities would not be able to continue doing it.
And last week on my trip there were a number of people who told me about the story on the two soybean ships that were not able to unload in China because their buyers had gone bust meant that whenever there’s bad news it’s just amazing how quickly it gets disseminated. So, yeah, I’m sticking with my view that this is a secular change and you can’t just use the formulas that worked in a short economic cycle in the US.
You know, if it had been this way in the 80’s, then when we got the new bull market going you should have been loaded to the eyeballs with US automobile stocks and you would have missed out on the stocks that did well in that cycle which were the ones that didn’t have Japanese competition.
So that was the first time that Asia changed the way our stock market performed and I am still of the view that it’s going to change in this cycle, but you’re right the last…since the Avian flu incident, which was mid-January, what we’ve had is, we lost the real buyers out there, and then we lost, because of this basic theory, we lost the ones who regarded them as deep cyclicals that you play during a recovery.
So it left us sort of short of finding somebody who still believed. So we should know about this within the next few months. But I can tell you that my trip to Europe, I talked to what is a tidal wave of money that does believe that there’s going to be a big commodity cycle in this cycle and they’re just waiting to see how the China story plays out. If they once get convinced that China’s not going to crash, given the tiny market cap of these stocks, we’re going to see some big moves.
And meanwhile, of course, what we’ve had is that the energy group which is still by far the heaviest weight it’s worth more than all the other industrial materials put together, has been a good place to be. So when materials by themselves, which includes all sorts of things that are manufactured, from hydrocarbons have been a bad place to be. But I’d be surprised if it lasts.
Any other questions?
Thank you all we’ll talk to you next week. |
