Where Is the Bottom?

"Many will be restored that now are fallen and many shall fall that are now in honor."

Where is the bottom? At this point, it doesn’t seem like there is one with banks and mortgage-related companies. Several very good companies’ stocks are down more than 50% year-to-date, yield in excess of 10%, and in many cases trade below book value. I’ve seen many of them trade down 5-10-15% in one day on no specific news. Fear is pervasive. Investment capital continues to shift to commodity-related companies – energy, materials, industrials – which continue to perform well, from bank and mortgage-related stocks – on concerns about bad loans – which are performing terribly. Yet the degree of stock price selloff in many cases is disproportionate to the actual levels of economic value that may be impaired by escalating loan losses. Eventually, stock prices will reflect the companies' true fundamentals.

While it is nearly certain that many banks and mortgage companies will experience lower levels of profitability over the next few years, that profitability is well below normal. Yet the stock market is valuing many as if declining loan losses will continue indefinitely, all dividends will be discontinued, and book value will erode far beyond its current levels. While these scenarios are inevitable with some specific names that are less prepared for a more difficult credit and economic environment, several will do very well as market sentiment shifts.

It is important to keep a clear head in this environment. Investors seek to earn a total return on their capital over time and historically dividends have been a big piece of that return. At their current quotations, some financial stocks offer (growing) yields of 10% or better. This happens to be the S&P 500’s approximate average annual return over 70+ years. At those yield levels some very good companies trade for in the market today, one need not see any price appreciation from here to earn satisfactory returns over long periods. But when most of the problems seem resolved, the market is not likely to leave yields at these levels for long.

For those looking for a diversified way to play this opportunity, take a look at the Financial Select Sector SPDR (XLF), which continues to (not surprisingly) hit 52-week lows. It yields 2.8% and trades at 1.6 times book value. For those unwilling or unable to handle the short-term volatility, buy a long-term call option on the XLF out to January 2010 at a strike price of $30 (roughly its current price). Buying the calls now cost $5.75 for a net cost basis of less than $36 if shares are worth more in a couple years. Also attractive (and probably more so) is the iShares Regional Banks ETF (IAT).

The quote at the beginning of the post sums the case up nicely, and for those willing to venture into individual names there are opportunities for significant upside potential with little risk of permanent capital loss.

Full disclosure: No positions in the securities mentioned.