Good Evening: The major U.S. stock market averages declined on light volume today, and an outbreak of a new strain of swine flu was deemed the primary culprit. Upon closer inspection, however, it seems as if the sloppy — even hoggish — bank lending practices of the previous up cycle are as much to blame for today’s pullback as any potential pandemic.
While I was away late last week, stocks tried to best the recent highs they had set in anticipation of Friday’s release of the “stress test” parameters. The less than stressful reality of these tests for large banks proved anticlimactic, and equities were unable to muster the energy to reach fresh, post-March 6 highs. As such, the averages may have been looking for an excuse to retreat when the news from Mexico made the rounds over the weekend. A strain of swine flu known as H1N1 was reported to be responsible for more than 100 deaths in Mexico. Though no deaths have been reported in other countries, tests have confirmed that this flu has spread to parts of the U.S. and as far away as New Zealand.
In reaction to these reports, the World Health Organization raised its alert level and investors accordingly raised their level of concern during today’s trading. Fears surfaced that global travel would be disrupted and that overly cautious trade sanctions (e.g. pork imports) would be put in place. The playbook from the 2003 SARS outbreak was dusted off and put to use, with hotels, airlines, cruise lines, and casinos among the day’s biggest losers. Since H1N1 appears to be treatable with Tamiflu and other anti-viral drugs, it came is no surprise that biotech and assorted health care names were among Monday’s winners. Eyebrows were raised, though, when GM managed to gain 20% in the wake of an equity-for-debt swap offer that will likely gain little traction (see below). Short-covering and capital structure arbitrage strategies aside, GM common and the company itself will need enormous measures of both luck and skill to survive in anything resembling current form.
Stock index futures were indicating losses of up to 2% prior to this morning’s open, but the actual damage was approximately half that amount when the opening bell rang in New York. Market participants were soon of a mind that the media was over-hyping the flu story, and they managed to push equities back above unchanged before lunchtime. The averages then resumed sinking during a relatively quiet afternoon before closing just above their worst levels of the day. Helped by GM, the Dow (–.65%) suffered least, while the Dow Transports (-4.7%) understandably brought up the rear. Just as they did during the SARS outbreak in 2003, Treasurys performed well. A large 2 year note auction was quite well received, and yields fell between 4 and 8 basis points. The dollar was somehow deemed a beneficiary of the swine flu, and it rose 1.4% today. Commodities were much less fortunate, as fears of protectionism hiding behind a fig leaf of health concerns hurt almost every major sector. The CRB index declined more than 2%.
While it’s still early by flu outbreak standards, most health experts seem to believe that the H1N1 strain of swine flu is unlikely to reach pandemic proportions. If so, and I’m particularly unqualified to doubt medical professionals, to what can we better attribute to today’s decline in the stock market? I have two candidates and the first is a piggish rise in bullishness among large institutional investors. The latest “Barron’s Big Money Poll” came out this weekend, and the results display anything but doubt for the future of either U.S. stocks or the U.S. economy. Fully 59% of portfolio managers in the survey counted themselves as bullish on equities, while only 13% said they were negative. Readings of 4-1 bulls over bears are usually reserved for the frothier portions of bull markets — or, perhaps, at the peak of a vigorous bear market rally. As BAC-MER economist, David Rosenberg, points out in his piece below, the figures are even more striking (in the opposite direction) for Treasurys. 84% are bearish on securities issued by our government while a mere 3% are constructive. I may not be bullish on U.S. debt, but maybe the overwhelmingly bearish sentiment means it’s a bit too early to short them.
Given today’s 5% drop in the KBW bank stock index, my other candidate for an old affliction that might be responsible for weighing down stock prices today is the epidemic of shoddy bank lending practices during the previous boom. Infecting far more than just subprime residential real estate, this contagion spread to commercial real estate, leveraged loans, junk bonds, CDS, and even plain old corporate bonds. This strain of poor lending was evident in the narrow spreads seen for all types of credit in the run up to mid 2007, and despite repeated assurances from so many government officials and bank CEOs to the contrary, this problem is still not contained. The contagious desire among banks to extend credit to so many parties with hardly more upside than the generation of upfront fees is the real swine flu of our generation. And, just like its pandemic namesake, this strain of sick lending can be found all over the world.
Let’s look at Wells Fargo, a bank that has been in the news quite a bit of late.. The Bank of Buffett, according to the Oracle himself, stayed mostly out of trouble during the last cycle by avoiding doing the “dumb things” that so many of its competitors felt an irresistible urge to do on the lending side. “But they’ve never felt compelled to do anything because other banks were doing it, and that’s how banks get in trouble, when they say, ‘Everybody else is doing it, why shouldn’t I?'” (source: Fortune article below). As a Wells Fargo mortgagee myself, I agree with Mr. Buffett that Wells maintained a unique sense of discipline during the last cycle. But now WFC is lugging around the old Wachovia, which was a poster child of “me too” credit practices prior to its merger with Wells. Strictly because it now owns Wachovia, I’m a lot less sanguine about the future of Wells Fargo, a sentiment apparently shared by Dick Bove (see below).
This Rochdale Securities analyst has been favorably disposed toward banks for quite some time (read: bullish at much higher prices than these institutions fetch today). For Mr. Bove to cut Wells Fargo from a buy to a hold and question WFC’s cash levels and ability to digest the Wachovia transaction may thus actually be news. Mr. Bove agrees with Mr. Buffett that Wells is very well run, but he also agrees with me that Wells will be hampered by Wachovia going forward. Trying to keep up with the Joneses in New York, the Charlotte-based bank caught the “everybody else is doing it” syndrome so abhorred by the management of Wells and its famous shareholder. Let me repeat: I’m not saying Mr. Buffett is wrong and I’m not advocating anyone be short of Wells Fargo. What I am saying is that bullish market sentiment is already running a fever just as a flu scare strikes a global economic sentiment that is already bedridden. H1N1 may or may not have much of an impact on the world, but the real swine flu is still wreaking havoc.
— Jack McHugh