Portolio manager, Kristoffer Stensrud

It was expected that the markets would breathe a sigh of relief after a nerve-racking weekend, when the fate of two guarantors for half of the outstanding 12 trillion dollars in US mortgages was decided in the bondholders’ favour. This occurred after the dramatic weekend just before Easter when investment bank Bear Stearns was saved by taxpayers via J.P. Morgan.
 
The outcome was not the same this time round. Despite many analysts’ attempts to talk up the financial sector, we are still staring into the abyss. Losses seem to be accelerating and investors’ desire to make up the losses up is falling. It seems that national banks are – as they should be – the lenders of last resort. This will not contribute to shareholders’ values being the first to be safeguarded. On the contrary. With public support comes public control. That the sector should subsequently give returns which are better than risk-free interest rates seems optimistic.

A good parallel may be found historically in the latest IT crash. From the peak in March 2000 to the trough on 9 October 2002, median shares (S&P technology) fell by a whole 81 percent. It is not difficult to work out that the process took two years and six months. The financial meltdown by comparison has so far taken one year and scarcely one quarter, the peak being 20 February 2007. The median share has not even halved. As of Friday 11 July, it has fallen by 40 percent, even after a long line of well-publicised catastrophes.

It is also worth noting that before 1982, financials constituted a very modest proportion of the world index. That was not particularly surprising. The sector was strictly regulated, return on net capital was poor, historically achieved results were weak and, since they largely owned financial assets, equity capital eroded somewhat more rapidly than inflation. Two separate circumstances caused the sector to grow considerably. The first was when the Japanese financial institutions went from having a well-founded fundamental history in the early 80s to experiencing super speculation in the late 80s. The aftermath proved to be gloomy; Japanese bankers’ share of the world index is 0.9 percent compared to almost 20 percent on Christmas Eve 1989.

Global financial companies’ share of the world index, which now consists of huge US banks and trans-European giants, rose from less than 10 percent in 2000 to 28 percent in the spring of 2007. As of Friday, the share has fallen to 19.8 percent, after inclusion of Chinese and Indian banks which had previously not been open to investment. It is still the leading global sector. The next biggest group (according to the rough MSCI evaluation) is energy, which even after having seen the oil price double over the past 12 months, only constitutes 13.9 percent. The sector (ex Asia) is now trading at book value. This can only be reasonable to a certain extent, because no one really knows what the equity capital is. But it doesn’t look like we are going to get return on equity in the near future.

The lesson once again seems to be: be wary of investing in the index and apparent values. Many asset holders thought finance gave value for money last year because the key figures were low. It has since become apparent that the key figures were wrong. A reality check would have revealed this – did the finance sector really stand for 28 percent of the world’s value creation last spring? With this as the backdrop, the rest of the investment year 2008 will probably be more focused on real rather than imaginary value creation.