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BKX in Bear Market

The post earlier noted that the VIX was at a 5-year high, indicating that we likely would see higher stock prices in coming weeks. The indicator leads us to believe that now is a good time to buy stocks.

The graph above (courtesy of Richard Suttmeer at The Street) is of the BKX (Philadelphia Stock Exchange Bank Index) and it shows that the Financials have entered into a bear market. They are down 10.6% YTD and are at their lowest point in over 4 years.

Historically, the BKX has been a good predictor of the fate of the broader large cap market. It has generally preceeded the performance of the S&P 500 and DJIA up and down by 6 months or so. We have never had a bull market in the broader stock market averages without the banks leading the way. It has just never happened.

The reason that the BKX reading is so important is that it is a proxy for the health of the US financial system. The stock market cannot perform well if the fundamentals of our economy and currency have issues. The current problems with the subprime lending market are leaking over into the big banks and brokers. Is the BKX telling us that we are going to have a major lending institution go under?

I can well remember the pain that the fall of Long Term Capital Management (one of the first and most successful hedge funds – you can read about it on the net and the negative impact it had on the financial markets in the 90’s) had on the stock market.

Even though the 90’s were a decade or more ago, we still have financial institutions that will, in hindsight, do dumb things accepting more risk than they are compensated for. With trillions of dollars in derivatives exposure, JP Morgan has positioned itself as the arbiter of risk and risk management. The same mathematical models that the subprime lenders at Bear Stearns (who are on the verge of bankrupting their third subprime hedge fund in as many weeks) used are being used by the bankers that price the risk on derivative instruments. My best guess is that these models will not be as successful as everyone (particularly JP Morgan) hopes. The mathematical models show that the investment risk in the derivative instruments is spread out so widely that no one can get hurt. This risk can be interest rate risk, credit risk, currency fluctuation risk, default risk, or anything else that the mathematicians believe they can model.

Unfortunately, the subprime market’s mathematical models showed that the default risk on mortgages was spread out so widely that no institution could get hurt – tell that to LEND and AHM, a pair of mortgage brokers that have announced that they will go belly up.

Any dislocation in the derivatives market will make the minor problems from the subprime market look like a blip on the radar. The subprime market is billions of dollars – the derivatives market is exponentially larger. It is definitely something that could throw the stock market into a secular bear, but more importantly, it could damage the banking system, throw the US (and the world) economy into a protracted recession, and crush the dollar.

The previous paragraph paints a fairly draconian outcome that is possible, but currently not likely – the derivatives market is currently operating as predicted (but so was the subprime market…until it wasn’t). It is our job as fiduciaries and money managers to assess risk in client portfolios. At the very least, maybe BKX is telling us that there is more pain to be felt in this correction before we see the next major leg up in the bull market. Both the VIX and the BKX have strong track records as indicators. When we see two strong indicators flashing divergent signals it is strong evidence that you want to reduce exposure to the markets weakest sectors (financials) and increase exposure to the markets strongest sectors (those with real earnings growth and pricing power – Ag, energy, metals, infrastructure, machinery, and defense), and keep some cash on hand for some opportunistic buying presented by the volatility in the markets.

That is what we have been doing over the last couple of weeks and we will continue to do so. There are some great bargains out there in our favorite investment themes. We are rotating into them with the expectation that a year from now we should see 20% gains or more on these names (absent the currently unlikely draconian outcome discussed above). Not all of these investments will work out – that’s just the way it is – investing in individual companies can be frustrating as CEO’s and managers are human and can make bad decisions that negatively impact earnings on a microeconomic level – in spite of having marcoeconomic fundamentals on their side. However, as long as the preponderance of the companies operating in our investment themes manage their businesses soundly and the macroeconomic fundamentals push these sectors forward, our clients will be winners no matter what the major averages do.

More later!