Mohamed El-Erian Knows When to Buy the Financial Stocks

Today's move by Standard & Poor's to slash the debt ratings on U.S. financials (MER, MS, LEH) might be a bit behind the curve, but it is probably still too early to buy these stocks.

At least if you buy into the thesis put forth by Mohamed El-Erian, Co-Chief Investment Officer and Co-CEO of Pimco, in this week's issue of Barron's. In an interview, which essentially summarizes the position El-Erian and Pimco have been taking for months, El-Erian lays out the one, and only, case for these stocks.

Business is unlikely to materially improve near term, and banks and brokers still need to right size their organizations (Ie. layoffs), until the financials are done with their recapitalization efforts, buying the equity remains dangerous:

If you are a bond holder, you want to be ahead of a recapitalization. If you are an equity holder, you always want to come in after. When people have been pushing the financial sector, they haven't made the distinction between what is is good for the bondholder and what is good for the equity holder.

The equity holder wanted to buy emerging markets after they recapitalized in the late 1990's, U.S. corporates after after they recapitalized in 2002 and 2003 on the back of Enron, Worldcom, etc. The timing is critical. For the bondholder's it's the other way around because a recapitalization lowers risk and therefore brings in spreads. And the people who are diluted are equity holders. Barron's

While David Einhorn's claim that Lehman Brothers (LEH-NYSE) will need to raise in the neighborhood of $75 billion to shore up their balance sheet is probably exaggerated, but many money managers believe Lehman will likely come back to market for another capital raise.

White knuckle time, again, for the XLF

Certainly, near term conditions remain challenging:

S&P expects a relatively meaningful deterioration in Lehman’s second-quarter performance owing to a generally slower business environment, additional write-downs on certain troubled exposures, and the negative effects of hedges due to basis risk and de-levering of the balance sheet.

And although Goldman Sachs (GS-NYSE) is generally believed to be in a better shape, the rumors of a share buyback at 85 Broad that circulated a few weeks ago were laughable given the environment.

The Financial Select Spider ETF (XLF-AMEX) is once again teetering at crucial support, and even the most ardent financial cheerleaders would have to admit that time, and more capital infusions, are the only tonic for what ails these stocks.

Buying them ahead of the completion of the process is proving to be a money losing proposition.

Profiting From Global Change
Barron’s
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