Banks lead markets bounce

7/28/2008


The major averages have rebounded from lows reached July 15, with the hard-hit financial sector surging on better-than-feared results for the June quarter. For now, our advice for subscribers is unchanged: Hold 15% to 20% of equity portfolios in a money-market or short-term bond fund; watch the averages; and look for buying and selling opportunities one stock at a time. Don’t be afraid to buy reasonably valued stocks that have rallied on strong earnings reports, and be quick to sell stocks no longer among your favorites.

Leveraged finance
With financial stocks surging on June-quarter reports showing huge loan losses and write-downs, the market’s bounce since July 15 has raised many questions among investors. Among them:

Why are financial stocks rallying on such poor results? Banks, brokerages, and many other financial companies were widely expected to post poor results, and most of the reports have exceeded Wall Street’s downbeat expectations.

Still, does it really make sense for the financial sector to gain nearly 30% in a week? Whether the sector’s rally “makes sense” is a question that will be answered in the months and years ahead, but huge share-price moves in highly leveraged companies can be perfectly rational. Consider a bank with liabilities of $95 billion and assets worth an estimated $100 billion, for a net value of $5 billion. If new information suggests the bank’s assets are actually worth $110 billion, net value triples to $15 billion. In other words, a 10% increase in the estimated value of the assets leads to a 300% increase in net value.

Do the July 15 closing lows represent significant Dow Theory points? For the July 15 closes of 10,962.54 in the Industrials and 4,657.56 in the Transports to qualify as significant, the averages need to stage significant rallies from those points. Generally, significant rallies retrace one-third to two-thirds of the preceding decline over three to 12 weeks. The Industrials have retraced nearly one-third of the May-to-July decline, while the Transports have retraced more than one-half of the June-to-July decline. With more time and a little more strength in the Industrials, the July 15 closes will represent significant Dow Theory points, meaning moves below those points would shift the Dow Theory to the bearish camp.

Has the market bottomed? While it is too early to say, bulls have some reasons for optimism. First, the percentage of companies exceeding consensus profit estimates is exceeding historical norms. Second, stocks are responding to earnings news favorably, with seven of the market’s 10 sectors up since July 15. Third, the broad market has rallied, with advance-decline lines and equal-weighted indexes bouncing since July 15.


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