THE GUTTING OF WHALES CREATED OPPORTUNITY IN THE BANKING SECTOR
It has become quite apparent that the market has its foot on the neck of former whales who seem to now be in a state of perpetual floundering. This is to be expected after great, well publicized runs that draw the attention of those who seek to feed off excess blubber that is cultivated during such periods. At the first sign of blood, they will swarm. There is a lot of blood in the water currently and there is a lot of swarming.
How much of an effect does this predatory behavior have on the markets? How much of a further dislocation in the markets can be attributed to a few great whales being stranded in shallow water while hundreds of sharks proceed to take bites of the flesh?
We're in a unique time period where these types of questions need to be considered. The migration towards investment ideas amongst money managers has become extremely uniform and coordinated over the past few years. They seem to be seeking out safety in numbers, despite the fact that markets inherently target this type of disequilibrium in asset allocation just as readily as a 300 pound lineman will target a 190 pound quarterback.
We have had a disproportionately large investment by fund managers into financial companies since the collapse of 2008. The analysis behind these investments may be correct on a pure fundamental basis. However, from a market predatory standpoint, such an opportunity for profit cannot occur without a dislocation taking place that challenges those who seek to experience disproportionally large returns on investment.
In 2009 thru the first half of 2011, we experienced the first stage of the valuations for financial companies decompressing under what was thought to be a "worst is behind us scenario". Fund managers, such as John Paulson, picked up on the fact that the governmental support of financial institutions and record low valuations equaled an opportunity for substantial profit over the next 2,5 or 10 year time frame.
Given the lack of original thought that exists on Wall Street, other fund managers decided to hop on the "limited risk to the downside" financial institution train. Suddenly Wall Street had a sector that continued to trade at historically low valuations that became quickly unbalanced as a result of small, medium and large money managers piling in.
It is only natural that the markets would target an imbalance such as this, where the opportunity to take out multiple targets with only a few shots exists. The European crisis is blamed, the reality goes beyond any fundamental issues and into the functioning of the markets.
The issue now becomes at what point does the line between the natural functioning of the markets turn into a self-reinforcing cycle of fundamental pain for the financial institutions that have fallen victim? At some point, should this cycle continue, the natural functioning of the financial markets begins to influence fundamentals. Rumors end up becoming reality as customers flee and counter-party risk skyrockets. It's at that point where the functioning of the markets morphs into a new reality for a company, the employees of the company and customers.
The question for those considering investing in the financial sector is as follows:
1. Will the functioning of the markets begin influencing the fundamental reality of companies in the banking/financial services sector?
2. How much of a discount in shares of banking/financial services companies can be attributed the functioning of the markets versus fundamental realities?
3. At what point will the market relent and allow banking/financial services companies to begin trading on fundamentals rather than their current predatory state driven by the natural functioning of markets?
It's my opinion that we are going to encounter several cycles of this type of behavior in the coming 1-2 years. The trade on the upside for financial sector will end up being a lucrative one. However, lucrative investments do not typically occur without a period of adversity for those seeking to profit. The larger and more widely followed the opportunity, the more potential for the markets functioning in their current manner exists.
Opportunities for intermediate term profits exist. We are nearing a point where that opportunity is to the upside. Longer-term we may have quite a few whales to gut before the market allows those with patience and appetite for risk to be rewarded.
