Saturday, May 16, 2009

The Most Important Stock Market Week of the Year!

From the Desk of Joe Rollins

Since tax season has ended, I’ve actually gotten to play golf a few times, which means I can take out my frustrations regarding tax season and the stock market on the turf. I’ve yet to decide if playing golf is a good release for frustration or not, but I quit taking golf seriously a long time ago because I know that otherwise, it’ll drive you crazy! However, there are still days when the stress level on the golf course is just as great as in the business world.

In high school, I was had the good fortune of being a gifted athlete. Unfortunately, the toll of growing older has diminished my athletic abilities, but in my younger years I could pick up virtually any sport and play it well. Even though I had no formal golf lessons (and frankly, was never very interested in it), I was able to play a decent game the first day I stepped on a golf course.

My father was an older fellow when I started playing golf, but he was always able to beat me over a full round. I could easily drive a golf ball twice as far as he could, but he would always beat me with his finesse game. Playing with my brothers and the other kids in the neighborhood, it was not uncommon for us to throw clubs and use unsavory words to describe a terrible golf shot (which happened often).

I only played golf with my father on rare occasion since he worked almost daily at the local church and finding time to play golf was somewhat difficult for him, especially on Saturdays when he would prepare for Sunday services. I do remember, however, one specific day we played together that changed the rest of my golfing life. On this particular day, while standing in front of the golf cart we were using I hit a particularly bad three wood that hardly went 20 yards. I threw the club down the middle of the fairway – much further than the golf shot – and used many loud obscenities to express my anger.

No sooner had I thrown the club and let out those offensive words did I remember that my father was sitting directly behind me – a man who never uttered a swear word in his entire life. Recognizing that I was clearly in trouble, I tried to figure out a creative way to not have to turn around and face the wrath of my father. Sure enough, his understated response taught me more than any capital punishment that could’ve been inflicted on me. Turning to face the golf cart, my father said, “It didn’t help at all, did it?” He was right; it didn’t help at all – the shot was still bad. From that day forward I’ve never thrown another club (although I have cursed a golf ball on occasion).

In the last year, I have often cursed the financial media; this has been one of those weeks. As I write this post, the stock market is trading down significantly for the week. In fact, the losses have been so great over the last few days that the spectacular gains we had in the early weeks of May have been wiped out. Given the title of this post, you might be surprised about the market’s poor performance this week. However, there are enormous positive undercurrents in the stock market recently, which I seriously doubt have been expressed in the financial media.

Last Thursday, the Treasury Department announced the infamous stress test that they had been working on for some months with the 19 largest U.S. banks. There was, of course, great anticipation and trepidation as to what the stress tests would reveal. I’m not sure that anyone understands exactly what was going on, but I can assure you that the media clearly misunderstood the process. I’ve tried to get a clear understanding of what the Treasury was trying to accomplish, but I’ve failed in that attempt.

It is interesting to note that 10 of the 19 largest banks required no additional capital at all after the stress test was performed. Given the criteria of the stress test, I am absolutely “blown away” that all banks wouldn’t have required additional capital under this extraordinarily extreme scenario.

First, it’s important to remember that stress tests are not uncommon in the banking industry. In fact, they are completed almost monthly by every large bank in America. In order to test the banks’ reserves for potential bad debts, each of the major banks do stress testing of their entire loan portfolio. In fact, stress tests are regularly audited by outside accountants, and there’s a good deal of scrutiny that is attributed to the expected loss reserves on the bank’s loan portfolio.

In this particular stress test by the government, there was an assumed loss rate that was even greater than the loss rates that were incurred by the major banks during the Great Depression. That struck me as somewhat unusual given that the Federal Reserve was forecasting a GDP rate for 2009 of zero, and a positive GDP growth rate for 2010 and 2011. Did they not believe their own numbers? However, for the purpose of this stress test, they assumed a loss rate greater than in 1933 and 1934 when the GDP contracted in double-digit range and unemployment in America was close to 25%. Whatever criteria were used, I think the banks came out with a good report card, for the most part.

The stress test is not the reason for this post’s title. Rather, it’s because of the incredible financial events that have occurred over the last week since the stress test was completed. Almost immediately after announcing the stress test, the banks lined up to issue stock and raise capital from the general public. Wells Fargo & Company set out to issue $6 billion in new stock, but since it was oversubscribed by a factor of two to one they eventually issued close to $8 billion in stock.

Morgan Stanley set out to sell $2 billion of stock and due to the high demand, sold $4 billion in only a matter of hours. Given how easy it looked to raise this additional capital, Morgan Stanley issued another $2.5 billion in debt just a few days later. U.S. Bancorp issued $1 billion in debt and $2.5 billion in common stock on Monday. The Bank of New York Mellon issued $1.2 billion in new stock, and BB&T issued another $1.5 billion. The speed (and ease) of the issuing of stock to cover these capital shortfalls have been nothing short of breathtaking. Have you read this anywhere in the media?

Sales of common stock since the January 1, 2009 have been unprecedented. So far, there has been $54.9 billion in new stock issued in a little over four months, which has been the busiest stock issuing pace since 2000. In the first few days of May alone, U.S. companies sold a total of $28.9 billion of shares and convertible bonds as compared to $6.5 billion in the entire month of March alone. In addition, there have been $13 billion of high yield (or “junk”) bonds sold since the end of April. Even this amount pales in comparison to the issuance of investment grade bonds that have had the best record levels since Dealogic began keeping track in 1995. Even the last independent, non-government owned automobile manufacturer in the United States was able to issue common stock. Ford Motor Company sold $1.4 billion in brand new common stock to the general public this past Tuesday.

To show the non-discriminatory nature of this floodgate of new money, Microsoft, who has never borrowed money in its history, sold $3.5 billion in new bonds. Given that Microsoft already has a war chest in excess of $25 billion in cash and no debt, it seems strange that they would need to raise an additional $3.5 billion. The incredible nature of this issuance of stock and debt was that in many cases, the debt had coupon interest rates that were only marginally higher than the highest quality of government-guaranteed bonds.

Am I confused? Are these not the very same banks that the financial media have in recent months been proclaiming to be insolvent? How could it be possible that so many of the banks proclaimed to be technically insolvent by the financial media are easily raising common stock from the general public and debt that bordered on investment-grade interest rates?

I couldn’t help but note that Nouriel Roubini (a.k.a. “Dr. Doom,” and a professor of economics at New York University), who’s been on almost every financial news program lately, keeps stating that every bank in the United States is insolvent at the current time. Further, Paul Krugman of The New York Times (who is also an economics professor at Princeton University and who won the Nobel Memorial Prize in Economics in 2008) has written a number of editorials recently proclaiming that the only viable situation for the banking situation in the United States is for complete and total nationalization of the U.S. banks. He has been overly critical of the Obama Administration for being too easy on the banking industry and says that only when the government controls every bank will Americans be assured of stability. I guess the millions of people around the world who are buying the stocks of these banks must not agree with these learned economists.

With all the good news regarding the equity flowing into the banks, one might question why the stock market has performed so poorly since the announcement of the mostly positive stress tests. There are some basic technical reasons for the market’s poor performance: In order for a company to be able to sell stock in the secondary market, the stock has to be sold as a discount to the market price. For example, if the an investor purchases stock for $100 a share on the open market, what incentive would he have to buy a new issue when it can be bought at the same price in the marketplace?

In order to encourage new investments, the companies that want to issue secondary stocks do so at a discount. As the new stock is issued at a lower price, the publicly traded stock will adjust down to reflect the issuance price. There has been such a massive underwriting of stocks in the last week that many of the major stocks making up the indices have been adjusted down to reflect these new discounted prices. Since these stocks are part of the major indexes, the indexes must fall.

Additionally, active traders do not help this situation. Recognizing companies will have to issue new stock, the traders will sell short the underlying security even before the secondary offer has even been priced. The idea is that they will force down the issue price and the stock will jump back to its original price once the secondary offering has been filled. Essentially we have only had three trading days during the week, yet close to $35 billion in new stock have been issued in only these three trading days. This enormous amount of new stock has used up a lot of available cash flow that might have been utilized to force stock prices even higher.

The reason that this is “the most important stock market week of the year” should be clear to everyone. Only a few short months ago, the financial media was proclaiming the banking industry in America insolvent and unable to move forward. This week, investors voted with their hard-earned dollars that this was not the case. Even though the Federal government proclaimed the U.S. banking industry to be $75 billion short on capital as of last Thursday, almost half of that has been made up in new stock offerings in less than a week. I have yet to hear the financial media proclaim that over half of the risk capital has been raised in less than a week, even with the stress test that bordered on the ridiculous. Capitalism is a beautiful thing to watch when greed is filtered out. Why are we trying so hard to eliminate capitalism in the U.S.?

I’m not trying to say that the financial crisis has come to an end. But I do believe that these factors indicate that positive healing is occurring. Good companies are now able to issue stock and banks are able to raise capital. As I have repeatedly said since the beginning of this financial crisis, no major U.S. banks will be nationalized, nor will they need to be. What started the financial fear were the banks; at least now we have fewer and fewer banks to fear. Even though there are many economists who believe in the socialized banking example in Sweden, it will not be necessary in America. We may socialize the automobile and health care industries, but not banks (not this year, anyway).

As usual, these are just my opinions. I could be wrong.

No comments: