The Case for Financials

I want to make the case for starting to put some money to work in Financial stocks. Please don't jump all over me before you read this. Here is the thesis:

1) The Federal Reserve has finally realized the seriousness of the situation and is committed to bringing rates down to stimulate economic growth. The Fed cut rates 75 basis points this morning, and will cut more.

2) Housing, as we all know, is in a deep depression. The latest report on starts show a drop to levels not seen since 1991. The market sold off on this, but this is actually good news as supply must be taken out of the market in order to restore balance.

3) Housing will also be helped during the Fed easing cycle, as the tidal wave of resets on mortgages hits in 2008. Mortgages will reset at lower rates than expected. This will mean less foreclosures than the market expects.

4) President Bush has announced a tax cut to also help the economy. It seems that both parties will work together to come up with some plan to help, despite the election year coming up. The announced plan was for a $150 billion stimulus package, but by the time it becomes law it will be larger than that.

5) The last quarter of reported GDP growth came in very strong at 4.9% for the third quarter of 2007. We all know that the official definition of a recession is two straight quarters of negative GDP growth, but lets assume that one quarter would be enough. The economy would have to contract almost 5% to reach negative growth. That is an extraordinary amount in an economy of our size.

6) The Financials, as measured by the large cap index, the XLF, is at $25.17, after peaking at close to $38. That is a drop of almost 40%, more than a Bear Market. At $25, the index is now at a level last reached in late 2003. It is hard to get a handle on valuation because book values and earnings are in "flux" to put it mildly, but clearly the stock prices are more grounded in reality than before.

7) The banking industry is recapitalizing fairly rapidly, with capital infusions of almost $100 billion from Sovereign Wealth Funds, and other foreign players. The rest of the world does not have an interest in seeing the United States financial system go under. That would be bad for business. After all, there is a reason why 36 countries store Gold reserves in a vault under the Federal Reserve building in Lower Manhattan.

8) Banks have started started to write off bad loans and bad investments from its balance sheets. Although the market sees this as a negative, it is actually the beginning of the end of crisis. Another point that some investors don't realize is that accounting rules forbid banks to "write up" these investments once they are put into the "other than temporary loss" category. This raises the possibility that once the market recovers, these securities will actually have a value despite being valued at nothing on the bank books. So one day, we will have a situation where bank book values are understated on a trailing basis, the opposite of the situation we have today, where bank and other financial book values are overstated on a trailing basis.

9) Newly tightened lending standards means that fewer bad loans are entering the pipeline. Underwriting departments are finally doing its job. Non performing loans, and loan write offs will eventually peak and then turn down. That is how the credit cycle works.

10)Despite all the investment write offs and reserving for credit losses, bank capital ratios are well above minimum regulatory levels.

11) The psychology is correct as well. Everyone thinks that the sky is falling. Panic is setting in, just the time to buy.