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[TTHQ Staff]

BEING STREET SMART
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Sy Harding
A HIGH RISK SECTOR? APRIL 1, 2005.

I’ve been ending most of my columns for the last few months with a warning to enjoy the rally while it lasts, because I expect the market will experience a serious decline this year, and that profits will likely have to come from positioning for the downside, in short-sales and bear-type mutual funds.

Which sectors of the market do I think are most vulnerable?

The market is being pushed over the edge by rising interest rates, which are being hiked to fight off rising inflation. There is also concern that inflation might get out of control anyway if interest rates are raised but not aggressively enough. Either way, higher interest rates are inevitable. Either way the stock market is probably in trouble, since it abhors either rising inflation or rising interest rates, due to the hurt either one can put on the economy. Under those conditions, the financial sector; including banks, brokerage firms, and consumer-finance companies; looks particularly vulnerable.

Due to previously very favorable interest rate conditions, companies within the sector have been very profitable, and therefore popular with investors. That has created somewhat of an overbought condition. For instance, financial sector stock prices have risen to the point that the sector accounts for 21% of the S&P 500’s weighting. While that is not as alarming as was the 35% domination of the index by the technology sector in 1999, it is significant.

One problem for the sector is that when an overbought, popular sector runs into trouble the bail-out by investors can also be exaggerated.

Of more concern, the perfect conditions financial institutions have enjoyed for several years have begun to turn around to bite them. The lowest interest rates in 40 years, lax credit approval standards, and discounts and rebates to tempt buyers to borrow and spend, have household debt at record levels. Now rising interest rates make it more expensive to carry that debt, especially since so much of it is in the form of credit-card debt and adjustable-rate mortgages.

Most adjustable-rate mortgages are linked to short-term rates, where the Fed’s rate hikes hit first, and those taken out a few years ago at the beginning of the refinancing boom, will increasingly be coming up for resetting. Meanwhile, all those easy to obtain new credit cards that were stuffed in mail boxes over the last few years have an interesting clause in the fine print. What it comes down to is that if the cardholder is just one day late with just one payment, that easy to handle low interest rate that made the card so appealing, goes away, immediately replaced by loan-shark like rates of 25% to 29%. The average consumer has $8,000 in credit card debt, and many make only minimum monthly payments covering the interest. When the interest on the unpaid balance jumps from 7% to 25%, those minimum payments spike up painfully.

Meanwhile, rising inflation in the form of higher food and energy costs, takes additional money out of consumers’ pockets, money that at the time the new debt was taken on, was expected to be available for monthly payments.

Banks and other lending institutions are required to set aside a reserve for estimated loan losses. However, most of them base those reserves on their current loan loss rates, not on what they will face in a period of significantly higher defaults. They have reason to do so, since raising their loan loss reserves would create hits to both their reported earnings and the book value of their stock.

Another problem for the financial sector is the flattening yield curve, which is created by short-term interest rates rising faster than long-term rates. Banks, brokerage firms, and mortgage-financing companies, profit from a form of the so-called ‘carry trade’. Hedge funds popularized the phrase, which describes their practice of borrowing short-term money at low short-term interest rates, then repeatedly rolling that short-term debt over at low rates, so they can keep the proceeds invested at higher long-term rates, such as in 20-year and 30-year bonds, pocketing the difference as profit. Since their trades at both ends are also very highly leveraged through the use of derivatives, the profits can be substantial. However, the strategy works only as long as the spread between rates is substantial enough to pay the expenses and leave a profit.

Banks enjoy similar ‘carry trade’ profits in favorable interest rate environments, by paying low short-term interest rates on savings accounts and CDs, and loaning that money out in the form of business loans and mortgages at higher long-term rates. But as the Fed hikes short-term rates and long-term rates don’t rise as quickly, flattening the yield curve, that profit margin narrows significantly.

Putting it all together; the risk that rising interest rates and rising inflation will create a sizable increase in loan defaults by consumers, that profit margins will be squeezed by rising short-term interest rates; and that investors are over-committed to the sector, leads me to expect the financial sector should be high on the list of potential short-sale candidates. That is not a recommendation, just a suggested starting place for your own research. In that research, if you prefer to sell individual stocks short, be aware that care must be taken within the financial sector, since some financial companies are better positioned than others to weather a storm.

Sy Harding is president of Asset Management Research Corp., DeLand, FL, publisher of The Street Smart Report Online at www.streetsmartreport.com and author of 1999’s Riding The Bear – How To Prosper In the Coming Bear Market.