"The unfortunate thing about this world is that good habits are so much easier to give up than bad ones" Somerset Maugham

Here we go again-another backward looking February economic number came out early this morning and for whatever reason- stocks reacted to it...

I mean, let's get real here. Why would anyone worry whether the GDP growth for Q4 2007 ended was confirmed at 0.6%? The original number has been reported weeks ago...I am struggling to understand why would it really change my perception on valuation of WMT or GS if the number came in at 0.7%? or 0.5%? Everyone already knew the number was low, everyone knew the reasons why (think "flip that condo" TV show)... What's more, most of the companies out there have already reported earnings for the full year 2007, and now the majority is getting ready to report on Q1 2008 results... The more I learn about this never ending focus on "meaningless backward looking" indicators, the more I believe that this media frenzy is one of the major reasons why average investors underperform the market. Reaction to "worthless" news triggers unnecessary emotional reactions which in turn lead to excess overtrading...

I've been trying to repeat my take on this many times here- stock prices should be driven by expectations of future results, not past... For example, in my opinion it is absolutely irrelevant how much revenue or, net income for that matter, Beazer Homes or Pulte Homes had in 2005 or 2006. These "go-go" times simply aren't coming back any time soon. The only thing that matters for anyone trying to value these stocks now, is simply estimating how much cash they can hoard from land and inventory sales, how much debt they have to refinance in the next 12 months or so, and how long will this never ending industry slowdown is going to last...

Anyway, enough rambling- here some of my thoughts on the recent developments in the financial sector specifically...

On the positive side, conditions have improved markedly in the commercial mortgage backed securities market. Spreads tightened up dramatically with some of the higher rated debt trading back at the levels not seen since late January... This is a very positive development for most financial institutions out there, especially "real" banks like JPM, BAC and WFC. Also the fact that some of the most conservative insurers stepped in to buy the AAA rated commercial backed paper is a sure sign to me that the worst could be over for now in the CMBS market... Another positive is that Visa's succesful IPO has provided some badly needed capital for most major players in the financial field at the time when it was so badly needed. Cash raised in the IPO will help with liquidity fears and, in addition, paper gains from the offering will also cushion a big chunk of expected write downs thus preserving the bruised capital base...

However, on the negative side, I think that rebound in prices of most investment banks specifically could be overdone. The truth of the matter is that most of the phenomenal earnings gains achieved by Goldman and Co during the last five year were driven by increased leverage and booming M&A/buyout related activities. Both of these factors are no longer relevant.

Bear Stern's bailout has likely marked a beginning of a new era in the development of standalone investment banking ("IB") houses. It is very clear now that the amount of regulation related to IBs activities is going to increase exponentially in the months/years to come. This additional regulation will lead to lower leverage, lower average VARs ("value at risk") and higher expenses. In addition to that, while global M&A activity is obviously going to rebound somewhat in the next few quarters, the "golden age" of private equity is over, period! No "if"s and no "but"s- the "package and sell junk with no consequences" model of debt distribution is NOT coming back any time soon, which it turn means, that one of the main sources of hyper "growth" in 2003-2006 is now going to slow to a trickle...

All of the above does not mean that Goldman Sachs, Morgan Stanley and Co are all of sudden going out of business tomorrow... I think that while another run-on-the-investment-bank is possible, the implicit goverment guarantee of counterparty risk, should help with any silly BK rumors. Let's be objective- GS and Co still have best in class franchises in asset management, fixed income and commodities trading, M&A advisory services etc. But the problem is that even in these well performing units, the now almost inevitable deleveraging, very likely means that single digit trailing P/Es, hold very little predictive value on the relative attractiveness of the sector when compared to the overall market.

Simply put- investment banks of "yesterday" and "tomorrow" are likely going to end up looking so different, that all of sudden one day someone is going to ask a question- why in the world would such a super cyclical and highly leverage company like an investment bank ever trade at a ridiculously expensive double digit P/E multiple? To me, standalone IBs are not that different from someone like a high volume manufacturer of semiconductors- they are both cyclical and highly leveraged. In one case this leverage is financial and in the other operating- but in the end as many investors now have found out - all leverage is evil as it tends to work it magic both ways...

Anyway, stay safe out there, ignore the BS on TV and avoid the IB stocks- they aren't yet cheap enough to be a a real deal...
SkepticalCapitalist@gmail.com