Ken Kam's Best Ideas Blog

Market Outlook

There is tremendous amount of uncertainty in the market right now and investors are looking for signs of direction. Unfortunately, those signals are mixed so the market is reacting schizophrenically, prices are volatile and that fuels the overall fear many investors are feeling.
The big risk the market is facing right now is a damaged Financials sector and the impact it will have on the whole economy. The big question is whether the Treasury, Congress, and the Fed can establish stability, restore confidence, and attract capital back into the banking system before we go into a recession while navigating us through the threat of inflation.

So far, the excesses of sub-prime lending and the false sense of security that securitization, agency ratings, and insurance gave, has led to about $400 billion of losses. We probably have a lot more losses to go.

Nouriel Roubini, a professor at New York University, has been saying since February that the losses could ultimately total between $1 and $2 trillion. Since then, organizations as diverse as the International Monetary Fund, Goldman Sachs, UBS, and Bridgewater Associates have all basically agreed that losses will be over $1 trillion. So it looks like there are more losses to come but those losses are not certain. They are dependent upon many unknown factors: interest rates, housing prices, the economy, unemployment, the dollar, etc.

More significantly, when banks book losses, their capital is reduced, and because of leverage, their lending capacity is reduced by roughly 10 times the amount of the loss. Thus, the recognition of $1 trillion of losses could result in a credit contraction on the order of $10 trillion. That would be a tremendous hit to our economy.

However, the loss of $10 trillion of credit assumes there is no inflow of capital into the banking system. With the uncertainty that potentially $0.6-$1.6 trillion of losses remain hidden on the books, potential investors are rightfully concerned about investing new capital into existing banks. The question is whether or not the steps that Congress, the Treasury, and the Fed take will begin to stabilize the banking system and the economy, restore confidence and allow the banking system to attract capital.

So far, however, the slowdown seems to have impacted the Financials far more than the rest of the economy. Howard Silverblatt, a Standard & Poor's senior index analyst, says, "earnings for the rest of the S&P 500 would rise 9 percent during the second quarter if banks and brokers were stripped out of it." So earnings are up but stock prices are down.

I think this explains why the "value" investors seem more confident about their investments now than earlier this year. Eventhough our best "value" investors are down this year, they take comfort that earnings growth provides them an increasing margin of safety against a falling market. Although they are finding good values, no one is expecting a quick bounce.

I don't think anyone believes the market can move signficantly higher until banks feel their capital base is secure enough to support making new loans. Since the Fed and Congress seem to be determined to do whatever it takes to make this happen the odds are good that they will eventually succeed.
Consequently, because this is such an uncertain time, I think we have to look for companies that can provide a growing margin of safety and be ready to change course if events unfold that make us change our outlook.