Wednesday, October 19, 2011

Tuesday Thoughts

AAPL has just missed consensus view -- its first shortfall in almost seven years. While I understand that there is currently a product transition going on in the iPhone, Apple's release was a poor one relative to expectations. Indeed, the whisper number was above $8.50/share, a full $1.50/share higher than the actual earnings reported.

The market's daily gyrations are causing more harm than good.

This setting of volatility is further hurting investor confidence -- at a time when it is already wounded.

JPM conducted a conference call on the European debt crisis this afternoon.

Below are the firm’s comments:

* A 200-billion- to 300-billion-euro bank recapitalization plan will be approved on Oct. 23. Banks will get up to nine months to satisfy the recap objectives (either through asset sales or equity raises). If the aforementioned is not accomplished, either the EFSF or the specific country where the bank is domiciled will make up the difference. Anything short of 200 euros or six months to satisfy the requirements will disappoint the markets.
* JPMorgan doesn't expect an Oct. 23 announcement of the Greek restructuring. JPMorgan puts the restructuring at 60% and expects the banks to object to this plan and more "discussion" to follow. The next 8-billion-euro support of Greece will be announced at the meeting.
* An announcement will be made on the EFSF subsidy at the Oct. 23 meeting. The EFSF financing will take the form of an insurance policy allowing the program to be leveraged by about 2.5:1 (up to 1 trillion euros), and the first 20% to 30% of losses of newly issued weak sovereign bonds will be guaranteed. JPMorgan says the size of the deal will serve to ring-fence Spain and Italy from Greece.
* JPMorgan remains skeptical that what is proposed will be effective, and the firm’s conclusion is that the equity markets will not ultimately like the outcome.

An interesting observation from Peter Boockvar of Miller Tabak on what the VIX consistently over 30 means:

Quantifying what a VIX consistently above 30 really means, today is the 59th trading day in a row where the S&P 500 has moved 1%+ between the high and low of the day.

Kotak -

[T]he financial stocks, which have been devastated for four years, are currently positioned for a buying opportunity. In Cumberland’s case, we have scaled into financials several times and taken up the weights in the regional banks. So far, that is proving the correct course of action. We have taken the overall financials exposure above market weight. We continue to be a scaled buyer in financials.

Ten days ago, the entire banking system of the United States was for sale below its stated book value. One could argue it was for sale below its tangible book value, which means you could buy all the banks in the United States at stock exchange prices trading for less than their liquidation value. Clearly, that is an absurd pricing level.

Are banks now sound? Answer: some are, some are not. Are there still problems ahead in the financials and in the banking sector? Obviously, yes. Is regulatory change an issue? Again, yes. Are earnings derived from net interest margin an issue? Once again, yes. Does that mean that banks are dead forever? Our answer is a resounding no.

The time to enter a sector and start to take up the weights is when it has been devastated in a bear market for several years and priced to an extreme. When you price the entire banking sector below its liquidation value, below its tangible book value, you are seeing a pricing level in a climate where all the bad news is known or identified. Only then are you are defining an entry point. Further, the financial sector has lost ten percentage points of the value share of the stock market since its peak. Think about this sector where it once was 24% of the market weight and derived 40% of the market’s earnings. Now it is 14% of the market weight. Its earnings are substantially down from the peak earnings that were extant five years ago when everyone wanted to own financials.

Nevertheless, while there will be intermittent trading (sardine) opportunities in the sector, I see these factors as valuation/profit headwinds for years to come:

1. The big money center banks are suffering under the burden of cumbersome and expensive regulatory initiatives; they are the piƱatas of populism.
2. Higher ROE businesses (e.g., prop trading) are being reduced in size under the pressure of No. 1.
3. The specter of low interest rates continues to pressure net interest margins -- and this won’t change for many quarters according to Fed. Bank industry profit models benefit from higher interest rates, as banks have an imbalance of rate sensitive assets over rate sensitive liabilities.
4. The capital markets outlook remains lackluster.
5. Legacy issues continue to be costly (e. g., mortgages), as measured by both legal expenses and losses.
6. Subpar worldwide economic growth and limited improvement in the employment rate suggest that the credit quality recovery of the past two years is maturing.
7. Earnings power models for the bank sector have been revised lower almost every quarter and probably still remain too high. There is little low-hanging business fruit left in the way of pricing banking products (e.g., the imposition of a $5-a-month charge for checking won't dent the secular pressures).

Asset Managers Are Vulnerable to Disintermediation

I would remain short asset managers, especially those such as Franklin Resources (BEN) that have had disproportionate growth in non-U.S. fixed income and are now exposed to the threat of disintermediation (bond fund outflows), retail investors' disinterest in equities and depreciation in bond funds’ asset values due to continued euro instability and the inevitability of higher interest rates.

Life Insurance Is Stupid Cheap

While life insurance stocks act nearly as poorly as bank shares and are similarly subject to valuation/earnings risk from an extended period of low interest rates, many of the other headwinds facing bank stocks are not apparent to the insurance sector. The recent share price weakness can be seen as an opportunity, as the industry's fundamentals remain on sound footing. As contrasted to the banks, earnings and ROEs are going to continue to expand, as the demand for structured, guaranteed financial products (as retail investors remain risk-averse and avoid the equity markets) continues the strong growth experience of second quarter 2011 in the quarters ahead.

At a 30% discount to book value and at under 7x projected 2012 profits, the life insurance sector is stupid cheap.


Nonrecurring items had a significant impact on results at the bank.

A number of significant items affected results at BAC.

In summary, nonrecurring gains of about $10.5 billion and nonrecurring losses of about $5.5 billion netted out about $5 billion of nonrecurring gains.

There are about 10.6 billion shares outstanding, so approximately $0.44 per share in nonrecurring gains to report.

BofA came in with a headline EPS of $0.56, or $6.2 billion, compared to the consensus of $0.20 for quarter.

Taking out $5 billion net nonrecurring items from the reported of $6.2 billion of income, on an adjusted basis, the bank only earned about $1.2 billion or $0.12 per share, according to my quick analysis, a miss of about $0.08 per share.

China's third-quarter 2011 GDP supposedly grew at a 9.1% pace, slightly below expectations of 9.2% growth and down from second-quarter 2011's 9.5%.

The German October monthly poll showed the ZEW's headline economic sentiment index dropped for the eighth consecutive month to -48.3 from -43.3 in September, below the consensus forecast in a Reuters poll for a decrease to -45.0. This was the lowest level in nearly three years.