US financial stocks up 30% last week

Jason Zweig's "Intelligent Investor" July 26 column for the Wall Street Journal says it is still not time to even "tiptoe" into financial stocks, even though US financials were down close to 50% year-over-year earlier this month.

I disagree with Zweig's reasoning. I add the word "reasoning" here because when it comes to the stock market, it is not only possible but common for logic to call for stocks to go one way while they end up going the other. This is especially true when bubbles or crashes are underway, since when the top or bottom is finally reached, you'll find the voices of reason were calling for a top or bottom long before. While I happen to believe financials and stocks generally are a better value and/or safer bet than they have been for months, that doesn't mean they couldn't go lower yet this year. There was a head-fake last fall when it looked like the subprime problem might just be a summer of 07 crisis, and then again in the spring when stock prices suggested the worst was over. This could be another dead cat bounce.

In any case, Zweig begins by drawing on Benjamin Graham's value investing book to define "speculative" trades as trades that don't promise "safety of principal and a satisfactory return" (although Zweig adds that even trades that promise both are "speculative" if they aren't the product of "thorough analysis" as well). This "either risky or unsatisfactory return" definition simply equates speculative trades with bad trades; however, since it's a starting point of modern portfolio theory that risk and return are inversely related.

If a 2% annual return is "satisfactory", then, yes, buying the stock of a financial, or any stock, is "speculative" since the principal is not as safe as if one just bought a Treasury bill.

I would rather define speculation as trading which is made in anticipation of reversing the trade later such that the expectation of profit is entirely limited to an expected change in the price of the security. An investment, in contrast, is the purchase of an asset for the income that asset is expected to generate.

By this definition shorting stocks and playing options are speculative, because these activities cannot generate income except by a change in the price of the security. If you can't find someone later to trade with and reverse out of your position, you'll lose everything. That's not the case with true investments. I hold a number of stocks where my cumulative dividends are greater than my initial investment, for example, such that I'd be up even if no one would give me a cent for those shares today.

A stock could be non- or low dividend paying such that the firm's income is reinvested for growth, meaning shareholders nominally profit by way of capital gain instead of by received dividends, but that just goes to the form of the income, not to the importance of the income. It is always possible for a shareholder to receive dividend income, and indeed a stock that can never pay a cash distribution from the issuing firm is ultimately worthless in terms of fundamental value.

In his attached video interview, Zweig takes issue with the accounting book values of financials by arguing that their assets are not as liquid as their liabilities, and I'll certainly grant that this characteristic is fundamental to deposit taking institutions. But to the extent this mismatch is a timing of cash flows issue, it is a duration mismatch that can be "immunized". I've generally made money in the market by buying from people who sell the stocks of companies with good assets because they don't believe the companies could realize that good value if they had to monetize those assets overnight. Their belief is entirely true, of course, but the liquidity fear is typically overdone. This too shall pass. If a firm's long term prospects are sound, it is unlikely to be undone by short term tactical problems. This is the 21st century, and investment bankers have been working for decades to engineer financial instruments that make concrete assets fixed in time and place into abstract assets. If nobody wants an underlying asset right there and then, that doesn't mean some financial measure won't be available to "departicularize" the asset's value.

In countries without developed financial systems, yes, liquidity crunches can be very dangerous because risks can't be diversified. But in the developed world, a major financial institution is unlikely to go down without taking much of the rest of the economy with it. Indeed, what's happening now is what is supposed to happen, in that everybody in the US and even outside the US is sharing in the pain; if this wasn't the 21st century we would have likely had a spectacular bank failure by now.

Zweig's points about real estate prices still falling in the US and an absence of share buybacks by executives are well taken, but the meltdown in financial shares has been global, and the exposure of a lot of international financial institutions to US real estate is relatively remote. Yes, I've just argued that the whole financial and even economic system is connected. But non-US banks can afford to wait out US real estate prices for so long as the major US institutions can remain nominally afloat. Zweig calls for diversification, but if you are going to diversify, why not buy the closest thing you can to the global stock market? If one is making a speciality bet on the financial sector, then make it on individual financials. The whole idea here is that some particular babies are being thrown out with the general bathwater because people afraid of nasties in the water aren't inclined to be especially discriminating when they are in a panic.

If you don't want to buy financial stocks at this juncture, do so because you believe they won't realize good values on their current assets over an extended period in the future as opposed to overnight.