Thursday 28th February, 2008

 

Crisis in the financial sector

 
 
 
 
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The financial stocks have all run down

significantly which

presents a great

opportunity to

purchase these stocks at low prices and

cheap valuations. What most investors are

sceptical about is their timing in purchasing these shares.

Many would not have expected the bursting of America’s massive property bubble to spiral into the crisis and possible recession that America, the world’s largest economy, is currently experiencing. The subprime fiasco is just the tip of a much larger iceberg in a country like America where citizens have been on the biggest spending binge in the modern history of the global economy.

The subprime crisis severely affected the US markets which sent up red flags to the rest of the world. The full extent of losses from the subprime fallout is still unknown while new disclosures are being reported almost daily.

The financial sector has inevitably been severely affected by this crisis which includes firms in the banking industry, brokers & asset managers, insurance, mortgage, and the specialty finance industries. The extent of these damages, however, varies.

Citibank, Merrill Lynch, HSBC, and UBS have all been in the headlines for writing off billion dollar losses. Major banks and other financial institutions around the world have reported losses of approximately US$140 billion as of February 2008.

In an attempt to cover some losses, these companies have also been cutting jobs. UBS was forced to announce a 1,500 job cut in October 2007, which was followed by a write down of US subprime mortgage investments by $10 billion, the biggest loss by a European bank.

In October 2007, Merrill Lynch & Co reported the biggest quarterly loss in its 93-year history as a result of their $8.4 billion of write downs which was almost double what the firm forecast three weeks before.

These financial companies have been receiving capital injections from foreign sources which have given hope to investors and the market.

In an attempt to replenish capital after record mortgage losses wiped out almost half its market value, Abu Dhabi injected a cash infusion into Citigroup, the largest US bank by assets. Abu Dhabi bought preferred shares that convert to stock and yield 11 per cent a year, almost double the interest Citigroup offered bond investors. In addition to Citigroup (to name a few), Morgan Stanley, Merrill Lynch, and MBIA are also receiving capital infusions from outside sources.

Diagram 1 shows the performance of the financial sector in comparison with the industry. As can be seen, from September to December 2007, the financial sector performed worse than the market. From late December 2007 to February 2008 the S&P 500 experienced a greater fall than the financial index due to the performance of the other sectors which would have weighed down the performance of the market.

The performance of the financial sector, year to date, has been down 7.45 per cent (as of February 22,) while the market as a whole, was down 7.85 per cent. It can be deduced that a large portion of the S&P500 performance is as a result of the poor performance of the S&P financials.

Let’s take a more in-depth look at the performance of the individual stocks in this particular sector.

For the year, UBS has experienced a fall in the share price to $33.65, bringing year-to-date returns of -26.85 per cent. Goldman Sachs and Morgan Stanley both have negative year-to-date returns of approximately 17 per cent and 16 per cent respectively with their valuations at $177.71 and $ 44.19 per share.

Among others, Citigroup, HSBC, Wachovia, and Merrill Lynch also experienced devaluations in their share prices as summarised in Table 1. However, Bank of America, US Bancorp and Wells Fargo have managed to maintain positive returns ranging from three to five per cent with share prices of $42.60, $32.91 and $31.44 respectively.

Currently, the markets are experiencing extreme volatility, reacting significantly to the slightest news reports, earnings releases and economic data which are reported daily. This will continue to happen for some time, which is causing investors to remain in their confidence level.

As can be seen in Table 2, the PE multiple of the S&P Financial Index is currently at 14.9 with an average 5-year PE of 13.8. It is estimated that at the end of the year, the PE is expected to be 11.15 while next year’s estimate is at 10.53 times. The S&P 500 carries a PE of 18.23 as compared with a 5 year PE of 20.7. The PE for 2008 is estimated to reach 13.74 for the S&P 500 while next year’s PE is projected to be slightly lower at 11.46 times which shows there is still room for further devaluations between 2008 and 2009.

The million dollar question we are all asking is: have we reached the bottom as yet? The financial stocks have all run down significantly which presents a great opportunity to purchase these stocks at low prices and cheap valuations. What most investors are sceptical about is their timing in purchasing these shares.

The perfect storm

Have these stocks hit bottom or are they due for further falls tomorrow or the day after? If investors were to purchase finance sector shares now, they must be willing to hold these shares for the long term in order to experience positive returns, and not sell them as soon as the market begins to experience a bit of volatility.

As more and more banks are reporting their quarterly results and earnings, investors are looking on in dismay as they continue to see ongoing write-downs. However, the bad news will eventually come to an end and the markets will begin to make a turnaround. This can prove profitable for long term investors who purchased their shares when the market was low.

Investors who have already taken a hit from the financial sector can take the opportunity to average down their losses by purchasing more of these shares (which would currently be valued at a lower price to the price at which they were purchased) in an attempt to decrease their exposure to losses.

For example, if you purchased 100 UBS shares at $46 at the beginning of the year, you would have an unrealised loss of approximately $29,000 as at February 21. If, however, you purchase 100 more UBS shares at the current price of $32.68 and in the long run the price increases to $45, you would have a net profit of $1,132 as compared with a net loss of $100 which you would have incurred if you didn’t purchase the extra 100 shares at the undervalued price.

Much has been written on the roots of the mortgage debacle but clearly the US consumer's insatiable appetite for debt, the unfortunate reversal of house prices and rising short-term interest rates have created the perfect storm.

Banks have already taken corrective action to ensure this crisis does not dig itself into a deeper hole. They are now tightening their policies and screening processes where student loans and car loans are becoming much harder to obtain. America is slowly learning from its mistakes and will eventually pull itself out of this dip in the economy.

During the 1990 savings and loan crisis and the long-term capital crisis of 1998, equities fell below 50 per cent and 32 per cent respectively.

Investors who purchased stocks at this level would have gained 50 per cent returns in the following two years.

As the saying goes, “History has a tendency of repeating itself.” Hopefully, we all have learnt from the past and the corrective actions that are being taken to amend the situation will prove effective.E-mail us at [email protected] or phone 623-0415/0416 /9360

 

 

 
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