Tuesday, December 12, 2006
Financials: Where The Risk Is
The virtual unanimity among investors that interest rates will either be low or really low (as reflected in the continued strength in bonds and financial stocks) suggest the best of the interest rate news (i.e. lower is better) is probably priced into interest-sensitive securities. So the question is; Is there a way to benefit from the earnings season given what the market seems to think about sectoral wide earnings? Which sectors seem most vulnerable to material "misses"?And what if the market is wrong about interest rates, which subsectors are the most vulnerable to a shift upward in the yield curve going into 2007? To the first question, it appears that the fourth quarter will prove uneventful (as far as gaming the reporting season) for investment banks (GS minting money again, though the stock was sold into the news) , commercial banks (JPM and C playing catchup with WFC, BAC; the latter two names showing relative weakness to the former two so far in December) , thrifts and secondary mortgage lenders (CFC, FRE, FNM) are no longer in the dog house . We're less convinced that property/casualty insurers can muster up 15% to 20% ROEs again, though another mild catastrophe season could make headline numbers look good. We think the stocks should be sold on strength.........and should also be sold on weakness. We view the mid cap p/c stocks as unusually vulnerable to any miss in 2007, given the extraordinary runup in stock prices since 2002/2003. Make no mistake, the earnings quality issue will come to haunt them. Just remember the debacles in the late Ninties with Fremont General, Reliance, Frontier, Gainsco, and many other high flying "growth stocks". As we get closer to reporting season, it will be interesting to watch how rotational trades affect some of the largest multiline, Life, and P/C insurers, all of which are trading at or near multi year highs, but primarily part of global liquidity bubble, which tends to lift all boats (kites, whatever) .