Monday, March 17, 2008


A number of readers who have been hit hard by this market are asking lots of questions. This is a scary time. Times have been worse but the old joke is true, that if your neighbor loses his job times are tough but if you lose your job there is a recession. The value of a lot of different asset classes have fallen in recent weeks. The big declines have cause a number of coiled springs to be pushed close to their limits. The eventual result will be a strong rebound. However, no one knows how long the springs will remain coiled.

One reader wants to verify that I believe JP Morgan-Chase is a good buy. I believe there are thousands of good buys available right now and JP Morgan is among them. However, I believe the normal rotation in finance will be to the small bank. Small banks should benefit greatly from the, once again, steep yield curve. By tomorrow, banks should be able to borrow for 2% while lending at much more than double that rate. With the current value of the US dollar extremely cheap, one can count on local and international businesses to expand in America. In my BMW example, where the company is laying off 7.5% of its German workforce while planning to increase its US workforce by 50% over 4 years, the key is that the new BMW presence will increase the number of parts and supplies purchased in America. Many companies will get a boost from the new business and many will need to borrow money to expand. Multiply this one transaction by tens of thousands and the result will be a booming business for small banks. Small banks generally have little or no exposure to the "sub-prime" mess.

Another reader wants to know about margin calls. The way the brokers report loan balances is confusing. The bottom line is that if you own $10,000 worth of stocks, the maximum loan you can have outstanding is $7,500. Most firms restrict lending a little more than allowed by law and only permit a maximum loan of $7,000. If the equity in the account falls below 30%, the broker demands a deposit to bring the equity balance back to the 30% level. If a deposit is not made, then shares of stock must be sold.


At or near bottoms, margin dollars become very high powered dollars. With perfect knowledge, one would borrow and buy all one possibly could right at a market bottom and he would then leverage all the way to the market top. The total return on invested capital would be extremely high. Of course, the problem is that no one knows where the bottoms are.

Here again, we know that the market is as cheap or about as cheap as it has ever been by a number of measures. For example, the equity put to call ration was not at an extreme on October 10, 2002 right at the market bottom. Today, this measure is even more extreme than it was back then. Today, there are several measures that are at or beyond levels not even seen in the fall of 1982.

Knowing that the FOMC has released massive financing to banks and broker-dealers does not force these firms to purchase assets. However, with tons of assets selling at depressed prices, a lot of assets will be purchase in the belief that these are being bought at or near the bottom. As soon as a few assets are "just missed", after another firm makes the purchase, the fear of missing the best buys will over come the fear of buying only to see lower prices still.