How the banking sector could derail the rally
By
MoneyWeek Editor
John Stepek Oct 01, 2009
Print this article
Banks: more bad news to come
In the three months to yesterday, the FTSE 100 had its best quarter ever since the index was set up in 1984.
The market rose by 20.8%, gaining 885 points over the period to reach 5,133.
That's some rally. But can it continue?
Banks look likely to write off even more losses
The FTSE 100 has rocketed in the past six months – along with every other global stock market. But the higher it gets, the more likely it is that investors will be in for a big disappointment in the near future.
One very good reason to be concerned is the state of the banking system. The International Monetary Fund's Global Financial Stability report came out yesterday. It doesn't look any uglier than it did last time it came out, in April. But that's still pretty ugly.
The IMF reckons that the global banking system will have to write off a total of $2,800bn in losses on loans and securities between 2007 and 2010. Up until the middle of this year, banks had only taken $1,300bn of that hit. So that suggests another $1,500bn remains to be written off over the next 18 months.
Most of these write-downs will come from losses on loans banks have made, as recession-struck companies and individuals default on their repayments. Most of the losses that have already been recognised came from the dodgy securities (such as toxic home loan-backed assets) that caused the trouble in the first place.
But won't everything be OK now that the stock market has taken off and investors seem to be clamouring to buy anything they can get their hands on? After all, investors are even buying Venezuelan bonds now. Surely they'll invest in any old rubbish – isn't that good for the banks?
Special FREE report from MoneyWeek magazine: When will house prices bottom out - and how will you know?
- Why UK property prices are going to fall 50%
- When it will be time to get back in and buy up half price property
Trouble is, even accounting for that, the IMF reckons that banks are still short of $670bn. What does that actually mean? Well, the upshot is that if banks have a great big chunk of losses still to come, then they'll need to hold on to more capital to account for that, and probably raise more capital too. And if they need to do that, then they won't be as keen to lend money to the likes of you or me. Pali chief strategist James Ferguson, spelled it out in a recent edition of MoneyWeek magazine:
"Banks… will be in no mood to make new loans. This does two things. It stifles the next generation of would-be entrepreneurs, as they can't get access to financing. And it also accelerates asset-price deflation – banks won't lend to the bidders at foreclosure auctions, so prices offered for repossessed assets plunge." Falling asset prices in turn reduce the value of collateral held against loans, meaning that banks become even more reluctant to lend.
You can read more of James's piece here: The G20's plans for banks would be a disaster for the real economy – or for more a detailed commentary on the banking crisis and the macro-economy in general, take a look at his Model Investor newsletter.
What's good news for banks is good news for governments too
On top of this, debt owed by the banks, as the Financial Times points out, has also "shifted markedly towards short-term maturities since the onset of the crisis, making refinancing needs peak in the next three years." So banks will also be fretting about their ability to roll over their debts in the very near future. Again, that's not conducive to lending more money.
Of course, the fate of governments and central bankers is now irrevocably tied to the banking sector. What's good for banks is good for them too. Why? Because they've staked their reputations on taking this route out of the economic crisis. If it all goes pear-shaped again, people are going to wonder why we spent all this time and money trying to bail the banks out. So there's every chance that the authorities will do their level best to give banks a cushy ride for as long as it takes.
But even given that, stocks are certainly not at bargain levels any more. In fact, according to Smithers & Co, reports the FT's Lex column, "the S&P 500 is now 35% overvalued on a cyclically adjusted p/e ratio basis". As for emerging market valuations, these "are off the charts… whoever is pushing stocks higher is brave indeed."
In his latest piece of research, Dylan Grice of Société Générale quotes value investor Ben Graham's views on the difference between investment and speculation: "investment is the discipline of buying any asset at a good price which protects you from an unknown future, buying with a margin of safety; while speculation, or trading, is the discipline of correctly predicting the future."
Grice is discussing government debt in his piece, but at these levels, it seems to be pretty apt for stock markets too. Stock markets at the moment aren't pricing in an unknown and rather threatening future – they're pricing in a perfect V-shaped recovery, with bells on.
Where to buy in now
So if you're going to get into the market, as we've been saying for a while, buy 'safe' stocks. As another MoneyWeek regular, Tim Price of PFP Wealth Management and The Price Report puts it: "Happily, what has lagged has been quality blue chip defensiveness. If the market does undergo a correction before the end of the year (and who knows for how long the… bubble can inflate), the stodgy blue chips will almost certainly outperform their more speculative cousins."
Of course, there are a couple of areas where banking systems look a lot healthier. For example, Asia, according to Eoin Treacy on Fullermoney, is the one global region where banks have raised more capital than needed to replace write-downs and credit losses. (For more regular commentary on investing in Asia, you should sign up for our free weekly email MoneyWeek Asia.) But you can get decent exposure to Asia via one Western economy which has also managed to scrape through the banking crisis in pretty good shape – Canada. You can find out more about the West's healthiest economy in this week's issue of MoneyWeek magazine, out tomorrow. If you're not already a subscriber, then get your first three issues free here.
Our recommended article for today
Stock markets can't go up indefinitely. And this rally is no exception. All the signs are pointing to a significant pull back, if not a complete return to a primary bear market. Here's why.
Published in
Stock markets
| More
articles
by
John Stepek
Related articles
-
Nov 20, 2009
-
Nov 20, 2009
FREE - MoneyWeek's daily investment email
Our free daily email, Money Morning, is an informative and enjoyable analysis of what's going on in the markets. Written by our Editor, John Stepek, and guest contributors.
Sign up FREE to Money Morning here.
