What Will Monday Bring?

After three days of misery, caused by a combination of potential Chinese fiscal restraint and Obama political expediency regarding bank and Fed bashing, investors are recooperating and wondering what Monday will bring. I believe we will see more selling as everyone knew stock prices were too high, but were playing a game of musical chairs as they wanted to continue to make money while momentum was pushing equities upward. Everyone thought they could exit before the downdraft.

Just as Massachusetts changed the political landscape, the past three days have reinforced what investors knew, but didn't want to accept. Stock valuations had been too high and everything was not improving. We aren't in for a quick bounce back. Gains should be protected and speculations reduced. Selling will continue, causing a significant sell off until prices reflect a more reasonable multiple of earnings growth.

As I laid out a few days ago, my positions have been lightened with only about 25 percent in stocks. The remaining 25 percent still hurts. I feel lousy. Recently opened short positions in DFS and COF have paid handsomely. A large long position in K-12 has been reduced to only 5000 shares as I wanted to capture the gain and I felt the company would tread water till next September when school districts and parents decide on internet education decisions. Luckily LRN hasn't gone down in the downdraft and I've been able to sell at good gains. My remaining positions are largely concentrated in emerging markets and international companies. I haven't decided what to do with those.

While the past three days have been painful, the percentage decrease has been minimal. I'll look for more vulnerable companies over the weekend and sell them on Monday. Some up days will present themselves, but the tide has changed and investors are starting to treasure capital which means selling. My suggestion is to lessen long positions and add negative positions. As Charles Barkley says " I could be wrong, but I doubt it."

More Bank Dilution Looms

Investors in financial shares have fared well this year as almost all are significantly higher than their March lows. Those that bought shares near the lows have obviously fared better than the original owners. But the time has come to be wary. Dilution looms, again, on the horizon.

Banks have had ready access to capital this year as they attempt to work through their myriad mistakes. First, the Government provided needed support, then hungry investors started lining up to buy financial secondary offerings. The result was the same: loans were written off, capital depleted, new capital acquired, and original investors diluted. Painful only for the original owners.

While mortgage and credit card loan delinquencies are still at record levels, commercial real estate lending was poorly underwritten and is now showing serious weakness, another capital consuming issue is raising its head. On January 1, 2010, FAS167 will take effect unless delayed. The effect will be that banks must set aside additional capital to support off balance sheet credit card receivables and other securitizations. Whether or not the assets are brought back on the balance sheet or not, more capital must be found to support the potential risk of implied recourse. The big credit card issurers, JPM,C,WFC,BAC,COF, to varing degrees, will be affected. Since current capital isn't plentiful, they will sell more shares and dilute the current base.

Several days ago, First National Nebraska, a moderate sized regional bank with a large credit card operation, filed to sell $250 million of new common and preferred securities. The major reason given for the decision was the need to support off balance sheet credit card securitizations. The decision to sell new shares was a difficult one for First National as it is owned, almost exclusively, by one family. They felt the need, and pressure, to dilute themselves to comply with FAS167. What do you think the professional, non-owner, managers will do? Yes, sell new shares to whom ever will buy them, Government or public.

Setting aside concerns about the remaining potential loan losses and adequacy of loan loss reserves, capital raising is coming again to the banks courtesy of the accountants and transparency. Bank shares will be worth less in 2010.