Former top gun Fidelity Investments stock picker Peter Lynch used to advise
investors to "invest in what you know" as the key to picking potentially
profitable equities. Thus, instead of analyzing endless investment arcana such
as price/earnings ratios or momentum oscillators, he said that the amateur
stock picker could do just as well by finding good products, be they laundry
detergents or instant coffee, and just buy the stocks of these companies.
One of Lynch's best picks, that of Reebok far before it got hot, was not the
result of diligent, MBA-level financial analysis; it
came into mind when he saw all the teenagers at what he had been told were the
cool local hangouts wearing Reeboks.
But what if it were the other way around? What if, instead of providing a nice
snug fit, a person who put on a new pair of Reeboks had their foot lacerated by
ground glass purposely sewn into the innersole, and still the stock rose? What
if a hot new instant coffee seeing its stock rally every day had on its jar a
warning to "consult your physician before using if overly sensitive to
arsenic?"
What if the proprietor of Monty Python's famed Whizzo Chocolate Company saw his
company's shares skyrocketing, even though prominent among the firm's product
line were confections such as "ram's bladder cup", "garnished with lark's
vomit", "cockroach cluster", "anthrax ripple", "crunchy frog", made with "only
the finest baby frogs, dew picked and flown from Iraq, cleansed in finest
quality spring water, lightly killed, and then sealed in a succulent Swiss
quintuple smooth treble cream milk chocolate envelope and lovingly frosted with
glucose ," and "Spring Surprise", the surprise in that treat being that it
features, after you put in your mouth, "steel bolts spring out and plunge
straight through both cheeks".
If you think that investors would never reward corporate performance such as
this, you haven't seen what's been going on in the share prices of some big US
banks and financial institutions lately.
A common moniker used to describe government infrastructure spending projects
ready to be funded is that the projects are affirmed to be "shovel ready", but
no project is more ready and eagerly awaited than to have the world's
stockmarkets dig and climb out of the deep ditches they threw themselves into
last September.
Much has been accomplished since most world markets bottomed out in early
March; the Dow Jones Industrial Average is up by more than 3,000 points, or
over 50%, but for most of August the rescuers seem to have taken a break, with
the benchmark index only rising 4% up to August 28, as opposed to an over 8.5%
rise in July. The rescuers probably needed a break; there's just so much more
further to go.
But like all the serious denizens of Bacchus know, that there's always a party
going on somewhere, so it was with stocks in August. That revelry was quite
surprising, for it happened to be located at what many informed observers quite
correctly assume to be American finance's most fulsome foundation of feculence,
the stocks of its major financial institutions.
Yes, you would have done a lot better than the general averages in August with
the BIX, the nationwide banking stock index that purposely excludes the shares
of the big New York "money center" banks - it was up about 20% for the month.
The banking index that dares to take a bite of the big apple, and its big
stocks, the KBW, struggled by with only about a 3% rise in share value.
So was that the moneymaking secret for August, banks and financial stocks, just
not very big ones? Was the market still punishing the big money-center banks
for their wanton and callous profligacy in tranching, bundling and selling all
those worthless mortgage-backed collateralized debt obligations? In pushing
capital towards smaller, even small town, American finance, was the market
finally offering up a belated mea culpa for being so disastrously wrong
in following the siren songs of those glittering metropolis lotharios into
worldwide catastrophe?
Not on your life. In the same way that St Augustine once pleaded to the Lord to
"make me good, but not just yet", American capital, reaching again for the
brass ring, is apparently out for another spin with Mr Danger.
Almost all August US stock averages, especially the ones that deal in finance,
are grossly distorted by the performance of just five singular names,
Citigroup, which was up almost 65% for the month to August 28, Bank of America,
up 21.5%, Fannie Mae, up 251%, Freddie Mac, up 287%.
In much the same way that the Yiddish word chutzpah is defined as a man
who kills his parents and then begs the court for leniency because he is an
orphan, investors in the stock of American International Group, the company
whose over-enthusiastic embrace of credit default swaps torpedoed the economy
of the entire planet when the company failed, actually had the chutzpah to
enjoy its now ward-of-the-state's 282% rise in August. (For an account of
credit default swaps see
Jaws close in on Bernanke, Asia Times Online, July 16, 2008.)
For the sake of comparison, Goldman Sachs, a bank now making so much money that
no one really knows or understands how, had to settle for a paltry, puny August
rise in its stock of under 1%.
Not only are these five delinquents August's best show in town, it's almost
that they were the only show in town. According to Matt Phillips in the Wall
Street Journal, for most of the month, trading in just these five stocks alone
has represented just under a third of the total volume on the New York Stock
Exchange. Last Monday, August 24, it was over 43% of total; NYSE volume being
accounted for by just these stocks.
Phillips has rounded up a now usual suspect for the extraordinary price and
volume moves - the "high frequency" flash trading I discussed last month in
relation to Goldman Sachs. (See
Goldman Sachs - the lords of time, Asia Times Online, August 5, 2009.)
I have my doubts as to whether these rallies result from flash/high-frequency
trading; for one thing, most of the exchanges banned flash trading following
its existence becoming public knowledge. I'm not sure that Goldman, or anyone
for that matter, would want to be rubbing the regulators' noses in the dirt so
soon after essentially promising to be forever more on their best behavior.
Also, high-frequency trading does not usually influence the trend, or
direction, of stock prices in the manner that something is doing with these
shares - unless Goldman Sachs is pulling a new rabbit through a very new hat,
high-frequency trading seems to be a stretch here.
Finally, if it is high-frequency/flash trading, it's not rewarding, as judged
by the becalmed stock price of the acknowledged sensei in the practice,
Goldman Sachs. There's not much fun in being a master of the universe like
Goldman if little peons can blow your ears off while leaving you behind the
dust.
On CNBC, Charles Gasparino suggests that this is all just small-time shorts
finally throwing in the towel with purchases to close out their positions; if
enough do that in a short period of time, it can have dramatic effects on a
company's stock price. Still, since most of these stocks had already bottomed
in the spring, the Gasparino hypothesis seems to imply that the shorts had held
onto these positions long after they had reached their maximum profitability
and were content to sit there and lose money with them from March until August.
So what was it that lit the fires under, in an American universe of about 6,000
traded stocks, these particular five stocks? What lit the new guns of August?
In the files that police agencies keep on criminals are detailed listings of
who or what are the other criminals or gangs the socially undesirables hang out
with; an analysis of the associations of the five here goes a long way to crack
the case.
Fannie Mae, Freddie Mac, American International Group, Citigroup and Bank of
America - these were all Paulson's Plunderers, the trigger men for the caper
that brought the world economy down to its knees starting in the summer of
2008, when Henry Paulson was still Treasury secretary.
After Bear Stearns fell in March last year, there were a few brief months of
peace that allowed laissez faire sycophants the opportunity to bleat on that
the entire financial crisis was a lion with more roar than bite. Now we know
that the actual economy had by then already entered the worst economic pullback
since the Great Depression, even as promises were made that the skies were to
be forever bright as long as the upper incomes were further fattened with tax
cuts from out of re-elected conservative administrations.
Then, in July, Fannie Mae and Freddie Mac began to stumble under the crushing
weight of the collapsing US housing market. At first, Paulson's US Treasury
thought that all these two government-sponsored enterprises needed was just
making the implicit guarantees of the pair a little bit more explicit, but this
tourniquet did very little to staunch the bleeding. On September 7, it was
announced that the two were being placed under "receivership", defined in this
circumstance as what professed free-market conservatives call nationalizing a
company when their ideology prevents them from admitting that they're
nationalizing it.
Lehman fell early on the following Monday, AIG the following day. By October,
the barbarians were well past the gate and were assaulting the throne, causing
an electronic "run" at Citigroup, then the world's largest private financial
institution. Citigroup necessitated a few successive US government rescue
packages before the stock stabilized early this year. Bank of America, this
August's stock-price laggard among the fabulous five, never seems to have been
in much of the imminent danger of collapse that the other four went through,
but it still walked away with US$45 billion of US government financial system
support/TARP money.
Adding that to the estimated $400 billion both the US government and Federal
Reserve spent to refloat the GSEs, the $150 billion bailout of AIG, Citigroup's
pocketing of $45 billion in TARP as well as its receipt of a government
guarantee of up to $272 billion of its potentially diciest mortgage derivative
debt, and you come to the conclusion that, in under one year, the US government
has either pledged or proffered about $900 billion just to these five companies
alone - roughly the low end of the range for the 10-year total cost of
President Barack Obama's health plan.
All these emergency system rescues and developments were the bastardized
orphans of the braying hounds of crisis; nobody, least of all former Goldman
Sachs Golden God Paulson, would have in calmer times adopted a plan to react to
a financial crisis in these peripatetic fashions. Indeed, just prior to the
Lehman catastrophe, there was speculation that Paulson was going to turn away
the next supplicant pleading for more government porridge, and, in doing so,
reaffirm to the markets that, indeed, no one was too big to fail.
Late last August, three weeks before the failure of Lehman and AIG, I expounded
on some of this thinking in that last, glorious summer of faux prosperity.
(See, Tough
love's fatal attraction, Asia Times Online, August 27, 2008).
The
question then becomes, have all these factors, particularly the diverse,
sometimes inchoate opposition to the manner in which the government financial
elite has recruited from the private sector is reaching back to save their
buddies (and their future jobs) in the private sector sufficient to stop any
further rescues of the financial sector? Is the next supplicant, maybe Lehman
Brothers, maybe once again Fannie and Freddie, to knock on the door of Paulson,
[Federal Reserve chairman Ben] Bernanke and [Securities and Exchange Commission
chairman Christopher] Cox saying that they're too big to fail going to be told
that, in actuality, they're not?
It's not hard to imagine the consequences of such a denial. However soothing
such a stand on free-market principle would undoubtedly sound to those seduced
down the Pied Piper's road by ideology, for the rest of us the results would be
catastrophic.
Then Lehman and AIG fell, then the deluge - it
was catastrophic. In the three weeks following, the Dow Jones Industrial
Average lost 3,700 points, about a third of its value.
Paulson's sentiments changed very quickly, as I described they would in that
August 27 article. As in John Lennon's 1969 song of the misery of drug
withdrawal, Cold Turkey, Paulson desperately wanted to once again start
feeding the financial system's addiction to the government needle - "Oh, I'll
be a good boy, please, make me well. I promise you anything, get me out of this
hell."
How Paulson, followed by Obama Treasury Secretary Timothy Geithner, got out of
his hell was to affirm, in statement and in very expensive deed, that most
major American financial institutions were, indeed, too big too fail. The
establishment of what blogger Barry Ritholtz calls "Bailout Nation" has sent
the US federal budget deficit and debt numbers spinning to record highs like
Las Vegas slot machines, and provided the seed for the gaseous inchoate
populism of the teabag movement currently savaging Democratic solons at their
town halls - but, as of yet, it has kept the US and much of the rest of the
world's financial system intact, something that was thought to be not at all
that certain back on Lehman weekend last year.
And a year later, on the stock market, the first are last and the last first.
Why?
For the answer to that, you can look to your own behavior. What prevents you
from doing really, really stupid things? If your $5,000 mortgage payment is
due, what prevents you from using that money to instead cover the two hectares
of the town's football pitch with 50 centimeters of cotton candy? What prevents
you, should you see your surgeon in the cafeteria prior to your scheduled
surgery, from slipping him some Scotch in his coffee when he's not looking? If
you're on an airplane that you see is passing over your neighborhood, what
stops you from opening the door, jumping out, and thus bypassing the terrible
luggage carrel lines?
The answer is that there would be substantial negative costs, in terms of your
health and wealth, to all that behavior. You would lose your home with the
candy stunt, an internal organ or worse with your surgeon's mickey, probably
your life leaving the airplane.
But what if this was not true, what if you were protected from the consequences
of your worst decisions? You blow $5,000, but someone is there to give you
another big check; you've got another surgeon to operate on you, or a parachute
to put on as you leave the plane.
In other words, if you were continually bailed out of your worst, most risky
decisions, wouldn't you do a lot more of them?
What is "too big to fail" but a government promise to bail out the banks come
what may? As investors come to realize the influence and motivations of this
now huge new market-influencing player, relationships and previously
established market practices are changing, and that's what we are seeing in the
outsized performances of Paulson's plunderers this month.
If "too big to fail" is no longer seen as a policy result to be avoided, but as
a free ticket for a bank or other financial institution to receive nearly
lifetime government protection, then it's not all that surprising that banks
that now see themselves as too skinny to receive the government protection are
trying to fatten up a bit.
Just in 2008, Wells Fargo's combined assets grew by 43% after swallowing up
Wachovia; JP Morgan Chase's increased by 53%, after it assumed control of Bear
Stearns and Washington Mutual. The Washington Post recently reported an
unintended consequence of the rush from the huge to the gargantuan; the bigger
banks, operating under the presumed guarantee of the government, are borrowing
cheaper than smaller banks in the money markets - lenders apparently, with very
good reason, feel that their loans to institutions that the government will be
forced to stand behind are a safer bet than loans to smaller banks and
financial institutions that the government might let fail.
As a result, local competition for customers among banks in America's small
towns and communities is becoming a thing of the past; America's vaunted
small-bank centered financial system, significant in the dynamism of the
country's small-business-based economy, may soon, in a manner reminiscent of
local retailers being put out of business and replaced by such national
competitors as Wal-Mart and Target, be signified by, from sea to shining sea,
just having a Chase or JP Morgan on one corner, and a Bank of America or Wells
Fargo on the opposite.
If both the banks and their investors feel that the negative consequences of
excessive risk, loan default and insolvency, are being handled by the
government, it can't be all that surprising that both the banks and their
investors are hungry to whet their palette with more of it. Some reports have
it that the big banks are wading back into the market for highly leveraged
mortgage-backed securities, the same type of instrument that sunk them the
first time.
But at that time they didn't have the implied government guarantee. That frees
the banks to make relatively risk-free decisions to take on more risk, and it
frees the bank investors to engage in the mad bidding for big bank shares we
are now seeing.
Mind you, this is in no way a prediction for endlessly sunny skies in the
financial sector as a whole; on the other side of the banks being protected by
the government camp's barbed-wire fence things are pretty lousy. Twenty percent
of US banks lost money in the first quarter, and these days not a Friday goes
by without the Federal Deposit Insurance Corporation's commissioner, Sheila
Barr's bank closure team being dispatched into the heartland to put more
financial institutions out of their misery - last week three banks, in
California, Maryland and Minnesota, met their fate as their doors closed for
the last time.
Already, 84 US banks have been seized by the FDIC this year, and its list of
"problem banks" has swollen to 416. Since it is highly doubtful to more likely
absolutely impossible that Obama will be sending out Geithner's cavalry to save
this bunch, as one wag put it recently in the Huffington Post, perhaps the best
operating investment philosophy for these curious times might be to "sell the
FDIC [small banks] and buy the TARP" (big banks).
It's not as if the Obama administration does not see the inherent dangers of
allowing the big financial institutions to plunder the countryside with too big
to fail, but, during the current moment, Obama can ill-afford the poll-busting
consequences of another Lehman shock, just as George W Bush and Paulson
couldn't.
The Obama financial reform plan, released in June, did not call on the big
banks to be broken or split up into more of a regulation-friendly size (the now
trademark Obama/Geithner caution in dealing with the financial system was once
again on obvious display there), but it did call for extra auditing, extra
"stress tests" for the biggies, presumably to steer them in the right direction
before they sail right off over another precipice.
Still, the entire financial reform effort has degenerated into one big
semi-public sniping match between Geithner and Barr; besides, one wonders just
how many more fights Obama will have the stomach for once he emerges bloodied,
battered and bruised - whether he wins or loses - with healthcare.
All these things are undoubtedly seen by the players bidding up the big banks'
stocks. Why not? This is probably as close to a sure thing as you're ever going
to get in investing. Heads, the extra risk pays off, tails it doesn't, but you
still get bailed out by the government.
As for Peter Lynch's dictum to "invest in what you know", well I know that this
system, one that rewards the corpulent incompetents of the banking system over
those who display innovation and entrepreneurialism, is just about the most
dysfunctional thing I've ever seen; it's a virtual plea for foreign scavengers
to come in and buy up the system's assets on the cheap.
Perhaps a future economics teacher, after lecturing on the previous historical
epochs of agricultural capitalism, feudal capitalism, industrial capitalism and
finance capitalism, will look down into his textbook to see the chapter heading
that covers our current era - "moron capitalism".
Julian Delasantellis is a management consultant, private investor and
educator in international business in the US state of Washington. He can be
reached at juliandelasantellis@yahoo.com.
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