Value Trap?

Good Evening: The lingering effects of last week’s disappointment with U.S. policy initiatives, renewed banking worries in Europe , and a weak G-7 gathering this weekend all combined to hit global stock prices today. That the SEC accused a sizeable financial entity with fraud and that Japan ‘s Finance Minister was forced to resign only added to the gloom. The major stock market averages in the U.S. now appear poised to retest the November lows, and we can only hope to avoid what Jeremy Grantham warns might be a “value trap”.

With U.S. markets closed for Presidents Day yesterday, investors had an extra day to stew over a myriad of negative press reports this weekend. Team Obama’s “financial stability plan”, or FSP, generated more detractors than supporters in media outlets ranging from print editorials to cable news gab-fests. Any hopes for bold action out of the G-7 meeting in Rome over the holiday were dashed when the only real news generated at the gathering was a stupefying press conference performance by Japan ‘s Finance Minister (see below). It’s bad enough that the economy of that island nation has been hammered of late, but it’s worse to see the man leading its financial sector accused of being in the same sorry state! His resignation in the wake of his press conference will no doubt give the ruling LDP a hangover during Japan ’s election later this year.

Personal problems in Asia were the least of the worries facing investors today, however, as both Europe and the U.S. had less symbolic issues to grapple with. European banks came under pressure yesterday and today when reports of trouble surrounding Eastern European banking establishments made the rounds (see below). In my forecast for this year, I had ventured the opinion that the next shoe to drop in banking might very well be among Europe ‘s highly levered institutions. With the banks in Great Britain already well on their way to being nationalized, and with so many banks located in and around the old Soviet-bloc countries facing insolvency, it seems only a matter of time before the major banks in old Europe need a(nother) helping hand.

Not to be left out of the negative news flow, the U.S. also managed to find trouble today. The Empire manufacturing survey fell more than had been expected, and the Housing Market Index could only improve one notch from an all-time low set during the previous month. Stock index futures are a decent weather-vane to check prior to the start of trading in New York , and this morning they pointed to a 3% decline blowing in from the North. The major averages were down 4% or so within the first 30 minutes before they settled into a sideways range for most of the day. A small rally attempt mid day was cut short by word from the SEC that it was accusing an offshore affiliate of Houston-based, Stanford Financial, of fraud that was both “ongoing” and “massive” (see below). Gotta hand it to the SEC this time; they’ve really come a long way since the Madoff scandal. They had evidence Madoff was on the hook more than a decade ago, but this time they are trying to land the fishy-smelling Stanford affiliate before actually waiting for it to jump in their boat.

Equities made a run at new lows after the Stanford story broke, but when those lows held, the bottom-fishers showed up to push stocks higher during the final hour. This 1% to 2% comeback in the major averages lasted less than 20 minutes, though, and stocks sank right back to their lows at the close. The KBW bank index was filleted by 10%, and the other indexes suffered declines of between 3.8% (Dow) and 5.2% (Dow Transports). Treasurys (and gold) were once again sought for safety reasons, and yields fell 10 bps to 20 bps. The dollar also benefited from the renewed interest in Treasury securities, and the greenback levitated 1.3% against its major competitors. As might be expected on a day centered on banking and recession concerns, commodities were clubbed. Crude oil declined more than 6%, the grain complex was weak, and only a healthy advance by the precious metals prevented even worse damage than the roughly 4% drop experienced by the CRB index today.

Quite a few bears, this writer included, thought the major stock market low on November 20, 2008 would lead to a nice rally lasting into early 2009. Referencing, by way of example, the 1929-1932 decline, most of us with a sense of history noted that the Dow enjoyed a huge bounce of nearly 50% between the November lows in 1929 (198.69) and the interim high in April of 1930 (294.07). It was when this recovery after the Great Crash failed that even smart investors (Benjamin Graham himself included) found themselves buying “cheap stocks” far too soon. Many 20%+ rallies punctuated the ensuing grizzly decline, and many investors swore off stocks forever by the time the Dow bottomed at in 1932 at 41.22. There were values aplenty on the way down back then, but the cheap names either got cheaper or they went bankrupt entirely.

I recount this episode not to predict that the next couple of years will bring similar hardship to stock market investors (though it’s quite possible), but instead as an introduction to “Part 2” of Jeremy Grantham’s Quarterly Letter (see attached). As you will read, Mr. Grantham covers quite a bit of ground in this new piece. With warnings, advice, and even a Mea Culpa or two, he could easily have entitled it “Stuff that’s bothering me these days”. Though his subjects range from the positive alpha of taking on career risk, to the general lapse of financial ethics, and even how bubbles lead to busts, one of his most important points is that “value traps” are symptomatic of financial crises. Low P/E and low P/B offerings make the brave buyer rich during recessions, but they can also be Chapter 11 candidates if the economy, as seems to be the case now, turns really nasty. Mr. Grantham glumly concludes his analysis, however, with one last caveat. While a classic “value trap” may indeed be in the offing, he sees it as “at best a 50/50 bet this year”. Unfortunately, Mr. Grantham concludes, the high probability bets are few these days. Whether or not the Dow and S&P 500 can hold their respective November lows, Mr. Grantham’s addendum to “Obama and the Teflon Men, and Other Short Stories” is a worthy read. After all, forewarned is forearmed.

— Jack McHugh

U.S. Stocks Tumble on Recession Concern; Citigroup, GM Fall

Allen Stanford Accused of ‘Massive, Ongoing’ Fraud

Credit Swaps Rise Globally Amid Selloff, European Bank Concerns

Steinbrueck Says Euro States May Bail Out Members

Japan Finance Chief Nakagawa Resigns in Blow to Aso


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