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Sector Analysis/Financial Stocks

Dow Jones Industrial Average 9757
Value Line Arithmetic Index 1565
30-Year Treasury Index 4.76%

The Big Picture for Stocks
We're most likely in the bear market side of the 4-year cycle, which could carry into 2006.

Technical Trendicator (1-4 month trend):
Stock Prices Down
Bond Prices Down

I recently offered a list of industries that could be vulnerable. Here's a recap of the list:

  • Retailing. The consumer is tremendously overleveraged and the risk to the retailing sector is large. A long and protracted period of weakness in this sector is a strong possibility. See the chart below, compliments of ContraryInvestor.com.

  • Largecap biotech. We have gotten so accustomed to the idea that science can produce drugs to solve any problem. The Vioxx problem is an indication that this may be an illusion. The big biotech and drug stocks are at risk.

  • Media. The traditional media no longer holds monopoly power. Yet these stocks are still priced as if they do.

  • Internet. The internet glamour stocks sport huge multiples of 60 to 90. They may not grow at rates that justify these multiples. Advertising rates could wane in a recession. While many of these companies have developed franchise names, increased competition is not out of the question. Cycles dictate that as soon as a company seems unbeatable and gets cocky, something happens to knock it down.

  • Utilities and REIT's. I may be wrong, but I sense that investors have bid these stocks up to unreasonable prices in order to buy dividends. These industries are also vulnerable to terrorist attacks.

  • Financials. We have too many banks, insurance companies, and stock brokerage firms. There is too much competition which will become evident in the next few years. The investing public has not made any money in stocks in several years, and they will soon give up on stocks and put their money in fixed income, which is less profitable to investment firms. Also, there is an increasing chance of a disaster because of too much leverage or derivative exposure. And when the mortgage origination boom stops, it will put a pall over at least part of this industry.

  • Homebuilders. The boom will not last forever and when it stops, these companies suffer severely. The bears have been so wrong for so long (including yours truly) that they are at the point of numbness, which may suggest a top.

The financial sector in particular is of some particular concern. This sector is now the largest sector by market cap in the S&P 500. It represents 20.6% of the S&P, up from only 6% in 1980. That in itself is probably a sign that the sector is over-owned.

I call your attention to some facts and late breaking events:

JP Morgan/Chase had a large earnings miss, reportedly due to a bad bet on the bond market. Banks, especially this one, are known to have large derivative portfolios. Morgan/Chase has Derivatives Credit Exposure to Risk Based Capital of 768%. This compares to HSBC of 285%, Citigroup of 264%, and Bank of America coming in at 208% (source: Contraryinvestor.com). There is a risk of serious problems here.

In the comments above, we suggested problems for lenders when the mortgage boom stopped. Well, Countrywide Credit announced a large earnings miss just for that reason. The boom is probably over and there is more bad news coming for the lenders.

Fannie Mae is also in the news. Management has been doctoring the books to smooth out earnings. But that is probably not the end of the story. Fannie's Equity to Total Capital Ratio is a scant 2.6%. This compares to 4.2% just ten years ago. This company may be too leveraged to withstand a real pullback in the housing industry.

Even venerable AIG is in the news in a bid-rigging charge with the insurance brokerage companies. This is evidence that, as I said before, there is too much competition in the financial sector.

The brokerage stocks have stayed out of the news. But I am concerned about this segment of the financial services industry as well. This business has been too profitable to support the fact the customers are not making much (if any) money. I suspect that there is on the horizon a dogged period of less profitability for stockbrokers.

We remain short the Financial Select Sector SPDR (XLF), as well as individual companies within the this broad sector.

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