A 60 to 80% downmove coming.
Frank,
Charles Peabody is quoted by Alan Abelson, Editor in Chief of Barron's, all the time. He predicts a 6% handle on bonds and has this commentary in my www.lemetropolecafe.com commentary. Wells Fargo will be on the hotseat too.
1999 Outlook and Themes Revisited
There were two fundamental themes that I consistently harped on during calendar year 1998. On the product front, I suggested that market sensitive sources of income would disappoint due to dislocations in the capital markets, while, on the geographic front, I suggested that the Asian flu would eventually afflict the Latin American economies. As a result of these themes, I heartily recommended being underweighted the money center bank stocks, and market weighted the regional banks. Year-to-date, the S&P money center bank stock index is up only 3.4 %, and has underperformed the S&P 500 by a whopping 23 percentage points. The money center bank stock index is also up only one half of the rise in the S&P regional bank index, which has also under performed the broader market indices. The BKX Index, which is weighted with the largest capitalization bank stocks – both regional and money center, has underperformed the S&P 500 by a significant 19 percentage points, to date, in calendar year 1998.
Despite UnderPerformance, Downside Risk Remains
I point these relationships out because some have suggested to me that, because of the severe under performance in bank stocks during 1998, they were bound to bounce back in 1999 and outperform. I vehemently disagree. I see no value in bank stocks at current levels and expect at least two more years of price weakness and 60 % to 80 % of downside. I will also reiterate my statement made earlier this fall. After a brief Fed-induced rally, bank stocks are likely to resume their descent. This next leg of the bear market is likely to be characterized by a "crash." By definition, a "crash" is characterized by illiquidity, and so, those that want to pare back positions must use the current price strength to exit.
Unintended Consequences Shifts Epicenter of Risks
As for the fundamental themes, I shifted my emphasis earlier this fall when the Fed began to ease in an effort to bail out the capital markets and when the world's government bodies set out to rescue Brazil. As I stated back then, significant changes in government policies will create unintended consequences and it is our job as analysts to anticipate where the next sea change will be. It is my belief that, as a result of the two previously stated actions, the epicenter for the next dislocations is going to shift both in terms of product and geographic orientation. On the product front, I have suggested that interest sensitive sources of income would be the next area of revenue disappoints. I'm anticipating the development of a "non-parallel" shift in yield curves in the developed countries. In short, a fall in short term rates will put a squeeze on net interest margins, while a simultaneous rise in longer term rates will create a host of disappointments within the agency security and mortgage banking marketplace.
Regional Banks are now on the Hot Seat
The combination of this change in Fed policy (to bail out the capital markets through interest rate eases) and the favorable price movements in regional bank stocks (as Wall Street pulled its "Buys" on the money center bank stocks only to emphasize their "Buys" on the regionals) caused me to rethink my stock position. As a result, in October/November, 1998, I started to shift my emphasis of downside price risk to the regional banks and recommended that this group be underweighted. Today, in light of the Western Bancorp news I strongly reiterate that stance.
"Developed Asia" Should be Watched Carefully
On the geographic front, I suggested that the market and economic dislocations would slingshot back and forth across the globe with the next epicenter of problems likely to be found in "Developed Asia" (as opposed to the emerging markets of Asia). I also defined "Developed Asia" as China, Hong Kong, Singapore, Taiwan and Japan. Simply stated, I have expected that these countries' efforts to support their currencies and manipulate their capital markets would result in severe recessions (particularly as capital flows collapsed). The resultant ripple effect should be massive credit defaults that reverberate around the globe.
Interest Sensitive Sources of Income Likely to Disappoint
Already there are anecdotal signs that both my product and geographic themes are starting to take shape. On the interest rate front, I would note that today Western Bancorp. (WEBC - $32 5/16 – Not Rated) announced it would have disappointing 4Q'98 EPS results. The company stated that "as a result of the recent interest rate decreases by the Federal Reserve, Western is experiencing a squeeze on its net interest margin. Western enjoys a very low cost deposit base with approximately one third of its deposits in non-interest bearing demand deposits. As a result, however, when interest rates decline on the asset side, there is a limited ability to similarly reduce the cost of funds. Therefore, Western has suffered a reduction in net interest margin." Later, in its press release, the company states that "it is expected this reduction in interest rates will continue to impact Western's net interest margin throughout 1999."
While some of the major regional banks will use "financial engineering" to delay the impact of these pressures, I expect that they eventually will emerge in the form of disappointing EPS in 1999. As for the second part of the equation in my "non-parallel" shift thesis, I would only note that the 30 year treasury yield made its low in early October at the height of the Long Term Capital Management crisis and in the midst of a shift in Fed policy. Currently, investors seem to be ignoring the recent back up in long term rates and the resultant drop off in mortgage "refis" as temporary or seasonal. However, if these trends persist into the New Year, the marketplace won't be able to turn a blind eye anymore.
On the geographic front, I would note that those bodies or groups that actively "supported" various capital markets in "Developed Asia" are re-thinking their positions. This hesitation is leading to renewed weakness in the Taiwanese and Hang Seng stock indices and the Japanese JGBs. At the same time, the recessions seem to be developing a stronger grip on these economies and the resultant credit defaults are occurring amongst some of the larger and more important corporate entities. As these defaults climb up the ladder of "size," they will increasingly have international repercussions.
Next Leg of the Bank Bear Market – A Crash!
Given my unequivocal and unabashed view that the next leg of the bank stock bear market (that began earlier this year and should last through the year 2000) will unfold in the form of a "crash", I urge investors to sell both their regional and money center bank stocks now!
Charles Peabody
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