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S&P500 ex-Risk ?

Here's an issue I have been mulling over, without a satisfactory answer: 

There have been many investment thesis (thesii?) over the past few years about the market which supported the bullish side of the ledger: Earnings were high, stocks were cheap, risk was moderate, the Fed model favored stocks over bonds.

Regardless of whether you found these arguments persuasive or not, global markets have gone higher. While the U.S. indices may have lagged the rest of the world's bourses, they too, have powered higher. 

Here's the odd factor: It turns out that many of the arguments made in favor of U.S. domestic growth have been based on an assumption that turned out to be false. To wit: The Financials, the largest sector in the S&P500, had legitimate, sustainable, normalized risk-based earnings.

That basic premise turned out to be wrong.

Picture a race car driver, going way too fast in the first half of a track. He puts up record breaking lap times, only to crash and burn in the last turn. His driving coach would say his risk-adjusted speeds were irresponsible.

That's how I perceive what has been going on with the Financial sector. It wasn't Fraud, but rather a reckless disregard for Risk that led to outsized returns on many big cap stocks in the group.

Merrill Lynch (MER) just wrote down $8 billion dollars, erasing 5 years of profits. Citigroup (C) dinged  $11 billion. Washington Mutual, (WAMU) Countrywide Financial (CFC), Bear Stearns, GMAC -- there seems to be an ongoing parade of mea culpas that are erasing not just quarters of profits, but years of earnings. And there are likely to be many more of these, as tier 3 assets get priced appropriately. (UPDATE: Morgan Stanley (MS) now rumored to take a $3-6B writedown)

What's truly astounding is that we may only be seeing the tip of the iceberg. Its possible that the big brokers and banks have $1 trillion in toxic debt on their books to be written down. That would equal decades -- not years -- of profits to be wiped out.

To paraphrase the WSJ, "the financial crisis is becoming Shakespearean comedy."

So here's the odd question that I have been wrestling with: Given what we now know about how the true nature of the S&P500 earnings in this group, what did the past few years of data actually look like? Now that the big Banks have erased nearly all of their earnings of the past few years, what should that data have looked like from 2003-2007 with most of the Fins as a goose egg?

I would like to see historical data adjusted for the S&P500 for the Financial sector's losses. Specifically, if we back out the earnings that turned out to be based on a reckless disregard for risk, what does the following data look like?

• What were year-over-year Earnings? 

• How cheap were stocks really?

• What were the actual risk adjusted returns?

• Were stocks as undervalued as the Fed model suggested?

Consider our race car driver from before. If he fails to finish the lap, his time gets voided. Any Financial compan's earnings are a function of measured risk versus potential reward. If earnings turn out to be based on far greater risk than assumed, and subsequent losses offset them -- i.e., they are not sustainable -- they too have been voided.    

Question for our mathematics wizard readers: Can we figure out an easy way to take the historical data, and adjust these reckless risk-based earnings, now that they have been wiped out?

I don't know the answer to these questions -- but they certainly are food for thought . . .

>

Sources:
Markets fear banks have $1 trillion in toxic debt
Sean O’Grady
The Independent, 06 November 2007
http://news.independent.co.uk/business/news/article3132507.ece

Why Street Bankers Get Away With Repeating Old Mistakes
DENNIS K. BERMAN
WSJ, November 6, 2007; Page C1
http://online.wsj.com/article/SB119431284681383384.html

Fears intensify for prolonged turmoil
FT Reporters
November 5 2007 21:27 |
http://www.ft.com/cms/s/0/4cd5c262-8bd6-11dc-af4d-0000779fd2ac.html

Tuesday, November 06, 2007 | 06:48 AM | Permalink | Comments (64) | TrackBack (2)
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Comments

Stocks are set to rebound today, and the economy's looking better than ever. I read that on the news this morning. What on earth are -you- talking about?

Posted by: CR | Nov 6, 2007 7:37:57 AM