Sunday, August 12, 2007

Mike Hull Responds to a Client's Concerns

Mike – My thoughts regarding the financial stocks are as volatile as the market lately. One day everything looks great -- the next day it's a disaster. Is there a calmer and more reasoned perspective? Thanks, Bill Bill, You must be setting me up for something. That's ok. I always love your questions. "Is there a calmer and more reasoned perspective?" (than one day everything looks great -- the next day it's a disaster, especially for the financial stocks) I think so. No, of course there is. Absolutely. That perspective lies in what we know, what's inevitable, and what we own. What We Know We could load up both sides of the bear & bull aisle with what we know and probably make a pretty good case that the economy and the market will find their way to healthy paths. The economic data already collected doesn't show much weakness, outside of housing: While growth in most areas of the economy has slowed, consumer spending continues to grow, as does business investment and industrial production. With a very low unemployment rate and loads of demand from a strong global economy, it would take a housing crash or a run-away credit crunch to throw the U.S. into a recession. Our view from the beginning cast doubts that the housing troubles would be wide-spread. Yes, it's a problem, but the bulk of the problem is falling upon a few large states where sub-prime lending was prevalent and where speculation needed to stop. And, yes, some of the more greedy finance firms fueling this will see their capital evaporate. Has this led to a credit-crunch. Absolutely. Banks are built to protect themselves from risk. Credit will get tight. This won't be fun. Yet, credit-worthy borrowers will still find cash available to them. And that leads us to "What's Inevitable ..." What's Inevitable First, both U.S. corporations[banks included] and emerging economies have built up significant reserves over the last five years. Both have accumulated immense and unprecedented profits since 2003. If they need it, capital will be available. Second, at the beginning of last week, Dick Green of said it so well: "The Federal Reserve's first priority is to act as the nation's central bank, and to ensure liquidity in the banking system. If the Fed feels that there is an unwarranted restriction of credit, they will act." In other words -- It's Inevitable. The Fed will not let these credit fears run our economy aground. They just demonstrated that in a big way: 1) On Friday, they announced that they stand ready to provide liquidity to banks with unusual or extraordinary credit needs who cannot find funding through normal channels. 2) And, they began walking the talk by infusing $38 billion into the U.S. banking system on Friday. The European, Japanese, Canadian, Australian and other central banks injected nearly another $100 billion to their banking systems. As Greg said in Friday's blog, the Fed has not stepped in to bail out bad loans; it has stepped in to ensure that the gyrating markets don't cause the banking system to freeze up. Will they do more of the same if they see the need? Absolutely. It's inevitable. It's their job. What We Own But, while I've danced around it, your question was really expressing concern for the financial stocks. Calling the total return for financial stocks this year (dividends +/- price changes) dismal would be an understatement. The five banks we hold in your portfolio have dropped 9.2% in price. With the dividends received so far, that return has been pared to - 6.8%. And, therein lies the key. The U.S. banking system will survive. It's inevitable. And, I'm betting, as you would, that the five banks you own will still be thriving well after you are comfortably into retirement. The "key" I mean to emphasize here is that whether you are living off this fund or not, we will own these banks (at least four of them) because we want them producing (dividend) income for you. Regardless of where the market takes their prices in the short-term, we believe, as they do, that they will continue to deliver good dividend growth. Over the last five years, those five banks have increased their dividends on a compounded annual basis by an average of 16.8%. They currently have dividend yields between 3.3% and 6.0%, average 4.8%. That alone makes them look like great bargains to the long-term investor. I don't see the risk as whether these banks could see their stock prices drop further this year or not. The biggest risk by far is that you or I would decide we didn't have the patience to watch these volatile stock prices and cash out at these prices. The last thing I want to take a Pollyannic approach to this. The reading I've done this weekend shows me that more than a few reputable people watching this truly fear the subprime-loan-housing-bubble-burst-credit-crunch will spread far enough to cause a recession. The Fed's Friday actions should help calm the markets, but it may not be enough to calm all the fear that is moving the market. The ride could get even bumpier from here. Yet, that same reading tells me the Fed has enough tools at their disposal to stem the tide and keep the economy on course. This isn't the bursting of the tech bubble in 2000. It is not the Asian Contagion of 1998. It is not 9/11. In each of these instances the Fed stepped in and kept the banking system lubricated. Ben Bernanke has gone so far in his writings to advise that the 1929 stock market collapse and following depression could have been avoided if the Fed had provided enough liquidity. I have to believe he'll be there for us now, but I believe it will take some patience. This won't end Monday. Mike