The Financial Sector Will Recover

Miguel wrote:

Now that it looks like the other shoe is dropping after all, are you willing to admit you blew it in guiding your subscribers to wade into the financial sector last March, or will you just keep denying it?

Let me see here, Miguel, we shot to a 48% gain in six weeks after buying our chosen play on the financial sector recovery. Then, there was a sell-off in May — which is perhaps what you mean by “the other shoe is dropping” — but even after the sell-off we’re still up 22% and holding.

Yes, in fact, I will deny that I blew it in guiding Kelly Letter subscribers into the financial sector at its lowest point on March 17. However, I’ve never been accused of blowing it on this call before, so I’m not sure why you asked if I’ll “keep denying” that I “blew it.” This is the first time I’ve had to.

For less antagonistic followers of my thoughts on the market, I offer the following expansion on this discussion.

The financial sector has a long way to go before it’s back to normal, but it will get there. Our investment in it will ride that recovery to what I expect to be triple-digit gains before we sell. Sector recoveries have been an excellent technique around here, as a simple reversion to the mean combined with spreading risk across many companies creates a great risk/reward ratio.

Specifically in the financial sector now, I see flickering improvement. The credit market is showing signs of waking up, thawing out, or reaching the end of its long hard wretch, depending on which analyst you ask.

Yields have stabilized and mortgage-backed securities are solid performers in that kind of environment. If the Fed holds rates here a while, those securities should get back on solid footing. BCA Research wrote last Thursday:

Commercial bank demand has also picked up, supported in part by expansion of the various central bank liquidity facilities. Finally, further tightening is likely in swap and mortgage spreads as Treasury issuance accelerates to support proposed fiscal stimulus.

There’s data showing that the credit market is coming around. It won’t happen overnight, true, but it will happen. Getting money positioned for a recovery works best when it’s positioned prior to the recovery, hence our bold and so far perfectly timed charge into financials.

This is one case where I don’t think it takes a lot of knowledge of the problem to see an opportunity. You don’t have to know the details of what happened. You just have to recognize some key factors in a repeating pattern:

  • The financial system has seen problems like subprime in the past and has always pulled through before.

  • That’s despite people always saying it would not because it was “different this time.”

  • It will pull through this time, too.

  • It’s best to buy at the point of maximum pessimism, and that always makes people angry. Witness Miguel.

Turning to the wise observations of market masters helps in times of turmoil. Chris Davis at the Clipper Fund made some great comments about this at the annual meeting:

The next point I want to touch on is financials and the current environment in the credit and capital markets. You know, Charles and I had breakfast this morning with Charlie Munger, who is a hero and mentor and somebody we’ve admired a long time. And he said, “You know, in a funny way, it’s always the same. It seems a little different, but it’s always the same.”

You know, my grandfather used to say that the four most expensive words in investing are: “This time it’s different.” And usually you hear those at market tops. You hear them as a justification for why we’re on a plateau of permanent prosperity, and why things won’t collapse. But you also hear them near bottoms. You hear, “No, this time is different. This time the system is going to collapse. This one is much worse.”

What’s striking to me is that we’re in a period of such incredible pessimism. I wrote in the annual report about the issue of Business Week that I read as I was writing the annual report. It had a melting house on the cover. And if you went through the table of contents, it was so striking: wireless growth is slowing, the end of free trade, bone cancer in women. I mean it was just one awful story after another.

And it brought to mind Buffett’s comment that he wants to do business in times of pessimism — not because he likes pessimism, but because he likes the prices it produces.

For another look at the kind of forecasting you can expect from Business Week, see my May 15 article.

Folks, to do well in the market, you must tune out the Miguels of the world. (No offense, Miguel, but you showed yourself as a perfect bad example at just the right moment.) Somebody has to be the voice of extreme pessimism that marks the bottom, so be glad for people who do what history said they would do, what the master investors expected them to do, what one day they’ll wish they hadn’t done, and listen carefully to their calls for the end of the world — and then buy what they’re willing to sell you on the cheap.

Don’t worry, they’ll be around to buy it from you again later, after it’s gone up 300%.

Keep my email address, Miguel. I’ll have some fine financial stocks to sell you once you’re convinced the system won’t disappear.

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