Morgan Stanley issued an interesting report on Thursday. They upgraded financials to a neutral weight, and I thought their reasoning was sound and creative.
The BKX, an index of financial stocks, is trading below book value and below book has often been the right entry point. A critic might say book will be written down yet again and what appears to be value will disappear. Valid point and I'll come back to it in a second.
Morgan goes on to figure that the financials should earn at least a 12 percent Return on Equity (ROE) during a cycle. I would be disappointed if it didn't get higher, but if a 12 percent ROE were achieved, the earnings generated would prove out that these stocks are trading at only 8x earnings. The timing might be off, but I think the rationale is sound. We need to get into the balcony and above the fray to try to make longer term judgements.
To the erosion of book value idea, I would like to point out a report the Bank for International Settlements issued the other day.
The BIS is a sort of central bank for central banks regarding economic research. They feel that the markdowns taken on AAA subprime bonds that were dictated by marking to the ABX index could be incorrect by up to 60 percent. And that the marks were 60 percent too great!
Since the ABX index is only two years old, covers only a small portion of its market, and is used by traders to make bearish bets, its prices are incorrect.
AIG , one of the stocks mentioned in the Morgan report, and a stock I own myself, has said much the same thing. They feel the marks they had to take on credit default swaps -- a different animal then that addressed by the BIS -- will prove to be off by billions of dollars and they will be marking up these assets over the next few years.
No one knows for sure, but I think the level of negativity has gone too far and an opportunity is at hand. But be forewarned, I have been wrong for a long time on these stocks !
Vincent Farrell, Jr. is a Principal of Scotsman Capital Management and a regular contributor CNBC.