The Buzz on Banks, the Fed, and GDP

Richard Bove's downbeat assessment of the recent stock rally, plus speculation about the Fed's next move

By BusinessWeek Staff

Economic data released on Aug. 11—along with comments on the financial sector from influential banking analyst Richard Bove of Rochdale Securities—appeared to give investors second thoughts about the recent stock market rally. Major equity indexes traded lower for a second straight session after a big rally on Aug. 7, sparked by a better-than-expected U.S. employment report.

The market action comes against the backdrop of the latest meeting of Federal Reserve policymakers, providing a bit of interest in what is typically a dull time of the year on Wall Street.

BusinessWeek compiled comments from Bove and other experts on market and economic topics on Aug. 11:

Richard Bove, Rochdale Research

In February 2007, the Keefe Bruyette (KBW) banking index hit a high of 121.16. By March 2009, it had dropped 85.3%, to 17.75. In August 2009, the index made it back to a high of 46.46, recovering 161.7% from its low. There is no question but that the decline in bank stocks mirrored a severe decline in industry earnings. The net income of the industry (based on the FDIC numbers) in the first quarter of 2007 was $35.6 billion. In the first quarter of 2009, it had fallen to $7.6 billion (the industry lost $36.9 billion in the fourth quarter of 2008).

There was another factor at hand, however, in the movement of the stocks. Psychology toward the banking group had moved dramatically along with the earnings. Each shift in psychology carried with it a change in how investors believed they should value banks. The recent rise in the stocks does not appear to be driven by a change in the near-term earnings outlook. It has been driven by a change in psychology. Thus, it is our belief that these stocks are trading on "fumes" and not reality.

Marc Chandler, Brown Brothers Harriman

Financials are the weakest sector in U.S. equities today, losing a little more than 2.6%. In addition to simple profit-taking, some contacts are playing up the FASB board meeting on Aug. 12. One of the issues reportedly on the agenda is to expand mark-to-market accounting requirements to a broader array of bank assets, including loans intended to be held to maturity. American Banker reports that the proposals may be formalized this week. The American Banker report says that the key issues are when to apply mark-to-market. The current proposal seeks to increase its usage. The eminently practical issue of how to value a broader range of bank assets on a mark-to-market basis remains unresolved. Nevertheless, some observers are concerned that the FASB proposal could lead to a new round of writedowns of bank assets.

Michael Englund, Action Economics

Today's U.S. economic reports revealed a notable weak round of wholesale inventory data through June, alongside smaller though notable sales shortfalls, that imply a big downward revision in the next round of second-quarter gross domestic product data, though the lower sales trajectory that bodes well for the second half of 2009. We also saw an even bigger productivity surge in the second quarter than the lofty gain we had expected, following back-revisions that largely paralleled the adjustments revealed in the last set of GDP and personal income data.

Given today's data, we now expect a big downward second-quarter GDP revision to a 1.8% decline from the previously reported 1.0% drop, to be followed with a 1.8% third-quarter GDP gain.

Signe Roed-Frederiksen, Peter Possing Andersen, Danske Research

The big issue at [the Aug. 12 Federal Reserve] monetary policy decision is whether or not the central bank will expand its Treasury purchases. We believe that the central bank will keep its schedule unchanged but that the door will be kept open for possible future changes.

Economic data have continued to improve and we believe that this will be noted in the FOMC statement. Inflation pressures on the other hand remain subdued. Hence we expect the statement to reiterate that the Fed funds rate will be kept exceptionally low for an extended period.

Overall the meeting could turn out as a non-event. Markets are pricing around 110bps of tightening over the coming 12 months primarily beyond Q1 2010, and we don't expect the FOMC meeting to alter current market expectations much.

That said, the range of possible outcomes is vast. Markets are likely to be unusually sensitive to the wording about the purchase programs or any signal regarding the future path of policy. Hence, we recommend to reduce fixed-income exposure going into the meeting.

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