Tuesday, April 1, 2008

UBS and The Market Rally

We’re off to an interesting start to the second quarter. Swiss banking giant UBS reported that it will be taking a $19 billion write-down and about a $12 billion net loss for the first quarter. This is on top of last quarter’s roughly $12.5 billion loss. $24 billionish gone in two quarters. So how far down is the stock right now? Well, it’s actually up 14%. Sounds like a bad April Fool’s joke. Too bad they didn’t write-off $40 billion – their stock might be up 30%!

So what’s going on here? First off, they’ve announced the resignation of their Chairman. You lose $20+ billion in 6 months you should probably lose your job. More importantly, the company claims to have substantially reduced its exposure to real-estate-related assets (subprime exposure fell to $15 billion from $27.6 billion last quarter) and will create a new wholly-owned unit to hold its remaining illiquid real-estate assets. UBS also said that it will be raising $15 billion of new capital, after having just raised $13 billion in February.

What does this all mean, and why is this stock and the market moving higher? Clearly, the market wants to believe that the company (as well as the financial industry) has put the worst of the credit crisis behind it and that there will be minimal future write-offs and plenty of additional capital raised. The fact that UBS is able to raise another $15 billion is also seen as a bullish sign since this would have proven difficult (at least on reasonable terms) if their balance sheet was too ugly. Finally, the bank’s Tier 1 capital will remain at a fairly healthy level for the time being following the capital raise.

As for moving the remaining exposure to a separate wholly-owned firm, UBS may be doing this to enable it to sell the entire lot at one time to a single buyer versus piece-meal in the open market. It seems that whether that happens or not, this move will allow UBS to "focus" investors on its “core” business since these poorly-performing assets will be segregated.

With the additional news that Lehman is also raising capital and that Morgan Stanley has further reduced its exposure to bad assets, it seems investors are eager to sound the all-clear and jump back into financials and equities in general. Is the worst really behind us? Was that it? From peak to trough the S&P 500 fell about 20% in 6 months - quite a bit less than the two-year 50%ish drop following the bursting of the tech bubble and relatively mild as far as bear markets go.

This credit bubble is the biggest bubble we’ve ever seen in dollar terms and in terms of breadth. Far more people are affected by falling home prices and rising mortgage payments than falling stock prices (although the combination is pretty lethal), and far more people are more dangerously over-extended when it comes to credit now than we’ve ever seen. Little of the damage we’ve seen so far has come from the obvious slowing of the economy. We still have that to look forward to.

Furthermore, although equity valuation isn’t as rich as it was at the start of the last bear market, the current P/E on the 2008 S&P 500 estimated reported earnings is still about 20x. Future returns are rarely exciting when starting from such an elevated level. It's also very likely that earnings estimates for the balance of the year are still over-stated and need to come down, particularly given the difficulties in the financial and consumer sectors. Weak personal income growth, rising foreclosures, a struggling financial industry, higher inflation, a lack of ready access to cheap capital, rising/high commodity input prices, and high equity valuation is hardly the recipe for a new and powerful bull market.

Given all of these issues, the odds that the crisis is over appears to remain low. Even if we’ve seen the lows in the market (which I doubt), it’s hard to imagine that we’re off to the races again. Bear markets are marked by intermediate and short-term rallies. These are called dead-cat bounces and sucker rallies. Look back to the 2000-2002 period. You see a number of 10-20% rallies during that bear market. I strongly suspect that what we’re seeing lately is another dead-cat bounce, just like we saw this past November and January. As the market becomes short-term oversold on strong negative sentiment almost any news short of Armageddon gets interpreted positively. That’s in part why a $19 billion write-down can result in an 14% rise in your stock.

We’ve been due for a nice rally. Markets don’t move in just one direction. Sentiment was so bad it had to improve - at least temporarily. I wouldn’t be surprised to see this rally continue a bit, but it should face a stiff headwind as companies start reporting first quarter earnings in a couple of weeks. I expect to see fairly cautious guidance from companies on the balance of the year and earnings estimates being reined in. I would be very hesitant to chase the market during this rally. However, the long-term thesis for commodities/precious metals is still attractive, and the recent pullback in this sector is healthy and is likely providing a nice opportunity to nibble.