Tack's Market Commentary 3/24/08

Market Commentary This Week:

Fully 40% of our nation's corporate profits come from the financial services industry, and the sector has been decimated following the credit crisis and fears that complex securitization has led to hidden risk on the big banks' balance sheets. But, after a recent rebound, many analysts are saying the worst could be over, and the big question in the markets this week seems to be: Have the Financials hit bottom?

Since hitting new lows on March 17 following the news about Bear Stearns, the index had seen a 34% decline since its June 2007 highs, and was down some 19% YTD on Monday. But, following the Fed's actions in the subsequent days and renewed optimism that the worst news has come and gone, the financial sector is in the midst of a huge upward surge. The NYK Index is up 12.3% from its intraday Monday lows.

Much of the carnage at some of the banks has been due to massive write-offs from bad investments in the market for CMOs (collateralized mortgage obligations). But, you can't simply blame the housing market. The creation and collateralization of complex securities has been both a boon and a problem for the industry. On the one hand, these new products have been a massive profit center to the banks, on another, the source of much of their ills, and, many argue, the source of the current credit crisis.

Many analysts believe we have seen the worst of the write-offs from the investment banks. The markets have yet to fully appreciate the positive impact of the moves to lower short-term interest rates, open liquidity loans up to investment banks and allow Fannie (FNM) and Freddie (FRE) to increase investments in U.S. mortgages by $200B.

Our guys say that the strongest players in the industry could see share price appreciation of 10-20% over the next year. Still, long term, uncertainty and questions about the sustainability of even current valuations still remain. And, many of the headlines in the near term will remain negative, e.g., CIT Group (CIT), Credit Suisse (CS), Goldman (GS) and Lehman (LEH) all with bad news this week. Some of the weaker banks could go bust or seek bailouts from larger firms, and analysts say that that much of the near-term performance depends on whether most of the risk is already priced into the share prices.

On a broader note, I talked last week about how a fall in commodity prices could be a precursor to a recovery in both the economy and equity prices. If this theory proves correct, then the news last week was encouraging. Gold fell sharply and the dollar gained ground.

Perhaps the most positive signal this week has come from the credit market, as this week, we've seen a pronounced steepening of the yield curve. The yield curve is the difference in interest rate on short term issues versus long term issues. In times of growth and relative stability, the yield curve is "sloping," with shorter maturities commanding lower yields and investors in long term maturites demanding a premium. In periods of economic uncertainty, the yield curve may "flatten," with investors demanding roughly equal premiums for both short-term and long-term debt. At Thursday's close, the spread between the 2 and 10 year note was 1.78 percentage points, double the 0.88-percentage-point long-term average. Last year, the difference was negative.

According to a Barron's article this weekend, Moody's economist John Lonski says the steep yield curve indicates that we are further along in a recession and that the situation will be better 6-12 months from now. And, a steep yield curve should help large commercial banks like JPMorgan Chase (JPM) and U.S. Bancorp (USB) over the brokerage houses, because a steep yield curve also allows financial institutions to borrow short-term money at low rates and lend it out for longer terms at higher rates.

The most recent developments all point to a possible bottom in the financials. But, the fundamentals are still pretty scary, and, as we saw with Bear Sterns, the current environment can change quickly, so tread carefully, especially if you are just entering now. It may very well be a dead cat bounce.

Weekly Recap as of close on 3/20: