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    Thursday, April 24, 2008


    What's Next

    What is going to happen next in the markets. I have no idea.

    I continue to worry that there could be a significant downside move. I think the chance is substantially greater than 50%. A move below 40 on the Nasdaq and 20% or more in the broad banking indices. Tech stocks are in better shape than the banks. They are going to experience substantial weakness as the US economy slows but consumers still want technology and tech business will still be able to provide it. The Qs have a P/E of 19.34 and price to sales of 2.34. The earning component of PE is going to decrease by 20% or more over the next 9-12 months and that could well decrease price similarly.

    A broad based bank index such as the BKX has a trailing PE of 10.86 but banks have all lost incredible amounts of money in the last quarter. (What is a PE when earnings are negative!) It is impossible to value banks today. Even the bankers don't know what their assets are worth.

    In an excellent book on Valuation published in 1996 Damordaran he mentions that it's almost impossible to value banks using the discounted cash flow method because it is so hard to understand how they earn money. He suggests a dividend discount model or compounding of ROE. This is interesting because I'm sure in the late 70's you could easily value a bank but in the intervening period something changed. They developed exotic instruments, applied substantial leverage and then moved their riskiest assets out of their financial statements.

    Banks are going to have to live with a fundamental re-rating of their businesses because of this lack of transparency. Banks appear to go through the following cycle:

    1. Environment provides for a reasonable profit
    2. Banks see their competitors making a higher profit
    3. Banks stretch for yield to show profitability like their competitors (Latin American loans in early 80's, subprime crisis now)
    4. The stretch-asset implodes
    5. Banks give back all the additional earnings (above the basic economic earnings they should have made) in writedowns and become effectively insolvent
    6. Government supports the banks for some time while they rebuild their capital
    7. Banks return to a model that shows a reasonable profit

    We're in stage 5/6 right now. Once we get back to stage 7 we will see much lower returns on equity and much lower dividends. The ROE and dividends will be representitive of the true economics of their businesses.

    All in all this provides a reasonable basis for being short tech and banks in a broad way. Sentiment is incredibly bullish right now and that could go on for a couple of months. I expect there will come a point over the next 4 months where both the Qs and BKX will be trading substantially lower and I'm positioned as such.

    This all needs to be taken in the context of a much larger, long, position in very undervalued stocks. These all happen to be in the resources sector.


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    Disclaimer and Disclosure Analyses are prepared from sources and data believed to be reliable, but no representation is made as to their accuracy or completeness. I am not paid by covered companies. Strategies or ideas are presented for informational purposes and should not be used as a basis for any financial decisions.
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