The "Wright" Time for Financials

11/04/2005 12:00 am EST

Focus:

Kelley Wright

Managing Editor, Investment Quality Trends

"It is when the situation appears bleak or the prospects unlikely that opportunity is most present," Kelley Wright, whose contrary view suggests falling interest rates. As such, he now sees opportunity in out-of-favor financials, including the troubled insurer, AIG.

"Ronald Reagan must be rolling over in his grave, as those using the Gipper’s mantra of smaller government and fewer taxes has been replaced with spending that could cause inebriated mariners to blush. It now appears that the Federal checkbook that never closes is a horror too terrible for bonds to imagine, resulting in an exit from the long end of the curve. What does this have to do with stocks? Only everything.

"When the interest rate on Treasury notes and bonds is lower, the total return potential for high-quality stocks with an established dividend is extremely competitive, particularly on an after-tax basis. Logically, when the interest rate on notes and bonds is higher, the competitive advantage for those stocks dissipates and the shares will struggle. This explains the current bear market in the financials, which suffer first and presage a general decline. Within those depressed shares lies opportunity, however, and the wait won’t be too long.

"We have an interesting observation. The euro dollar market is one of the largest markets in the world and unusual activity will often signal a change in the major trend. Without getting too technical, when traders purchase calls it typically means they believe that the price of the underlying security will rise in price and so they want to lock in the current price while it is low. So, when traders buy calls on fixed income instruments they believe those instruments will rise in price, and hence, their yields will decline.

"Significant buying of December 2006 96.25 calls means they believe those contracts will appreciate and interest rates will decline, about three quarters of one percent . The underlying value of these options contracts is into the trillions of dollars. The amount spent on purchasing these options is into the billions of dollars. This is to say this isn’t idle speculation; these are some of the savviest traders in the world telling us they see another big decline in interest rates, a little down the road perhaps, but backing up their opinion with a very significant financial outlay.

"This suggests our system is working, as our Undervalued category is overweight with financials, as capital has abandoned those shares from fear of inflation and rising interest rates. Are we early? Yes. Our system works because we are always early. As bottom-up value investors our system works because we are early. It takes courage to defy the conventional wisdom and ignore the hysteria to snap up a value when it is handed to you; thus the designation of the enlightened investor.

"So far this year, American International Group (AIG NYSE) was hit with an accounting scandal, a management shakeup, a devastating tsunami in Asia, and the aftermath of two of the largest hurricanes ever to hit the United States. Because of the global scope of its operations in more than 130 countries worldwide, AIG is uniquely positioned among our list of select blue chip insurance companies. At a recent price of $62, the shares are priced almost precisely at Undervalue.

In a recent filing with the SEC the company disclosed approximately $40 million in pretax losses from hurricanes. AIG also had to post $1.5 billion in financing collateral earlier in the year, a result of its debt rating downgrades. With a new management team in place and criminally guilty pleas from the former employees at the company, we have hope that AIG has now put the worst of these scandalous matters behind it.

"Unprecedented disaster has led to broad emotional sell-offs, driving shares to long-term low prices. Although these sell-offs are somewhat unpredictable, they also can provide rare buying opportunities just like the disasters that cause them. Particularly indicative of its strength is AIG’s fulfillment of virtually every statistical and fundamental benchmark used in our newsletter. Investors comfortable with short-term uncertainty should find shares of AIG an excellent purchase up to prices of approximately of $69.50, at which point it will enter a Rising Trend."

Related Articles on