C

Below is a chart and table outlining the 2009 year to date performance of the sectors within the S&P 500. The Technology sector has lead the way thus-far and the Financial and Utility sectors have been dragging down the overall index performance coming up on the halfway point of 2009. Along with sector performance we have also provided a table with the best and worst 10 performing stocks within the S&P 500 index so far this year.

It is nice to see that 2 of the top 10 performers in the S&P 500 index (S, FCX) are stocks that we have recommended on multiple occasions on ValueExpectations.com. VE.com recommended Sprint on 11/26/08 AFG Buys, 12/29/08 High Value Score, 3/13/09 10 Most Undervalued and Freeport Mc-Moran on 1/17/09 4 Stocks To Consider, 1/30/09 5 Cheap Stocks, 2/17/09 Digging Deep.

Average Sector Returns (S&P 500 YTD)

Average Sector Returns (S&P 500 YTD)

Best and Worst 10 Performing Companies YTD 2009 (S&P 500)

The Applied Finance Group

We recently reviewed Net Income (ex. Special Items) & Common Dividends for a list of 86 financial institutions in the S&P500 and made the following observations:

• The market value of equity has been reduced by ~ 65% since 2006 (from $2.66T on 12/29/08 to $945B on 4/24/09).
• The Financial Sector lost $173B (Net Income to Common ex. SI) in 2008 ($251B loss if Special Items are considered).
• Over 50% of the firms (44) have lowered dividends in 2009.
• The Financial Sector lowered Common Dividends by 68% or $41.4B ($19.9B in 2009 vs. $61.4B in 2008).
• 20 out of 86 firms posted Net Income (ex. SI) losses in 2008, which totaled $239B.
• 66 out of 86 firms posted Net Income (ex. SI) gains in 2008, which totaled $65.7B.
• Analysts are projecting $69.6B in Net Income for 2009 of which $64.1B is coming from firms that did not post Net Income losses in 2008.
  

Exhibit 1:

Notes:

Exhibit 2:

Exhibit 3:

 

Exhibit 4:

Would it not be convenient to have a warning stating the probability that a troubled stock blows up? Sadly, neither the NYSE nor NASDAQ offers such a service before one decides to invest in a stock listed on their exchange. However, with a few assumptions and a bit of algebra, we can take a look at the options market to gain insight on the implied probabilities of big bank nationalization. If the government nationalizes or takes additional significant equity stakes, equity holders could be wiped out. This possibility seems real, particularly given recent comments that at some point bond holders should share in the capital losses, a scenario we envisage would be concurrent with complete or near total equity dilution.

In order to gain some insights from what the option markets are saying about such a scenario, we need to make a few assumptions, which while not 100% accurate, nonetheless give us a perspective on how the market is assessing such an event.

We start by looking at the payoffs from buying far out the money puts on a long dated expiration option. We then compare that relative to the payoff from such an investment. To keep things simple, we define the probability of equity failure as the return on the option investment, relative to its cost. So if an option costs $1.00 and its return is $2.00 (in the case of an equity blow out), we infer that the odds of such a blow out are approximately 50%. Another assumption is that if the big banks become nationalized, the equity will trade to a floor of $0.50 a share, consistent with what we have seen from AIG and Fannie Mae. While we readily admit our analytical framework is rudimentary, we nonetheless believe it provides some insight.

For our analysis we looked at the farthest out of the money strike puts (for C, BAC, WFC, and JPM), the $2.5 strike, for expiration in January 2010. We make the admittedly aggressive assumption that with a stock price below $2.5, the banks will not be viable, and that in turn will lead the equity to trade down to a floor of approximately $0.50, a stock price quite similar to what has been witnessed in the case of AIG and Fannie Mae.

 Table 1 displays the information required to understand the probabilities the market is implying about each of these firms wiping out their equity holders. The column labeled Option, denotes the Option price; Floor is the assumed $0.50 traded value if the stock breaks $2.50; Return is the $ gain from the option investment if the stock trades down to $0.50; and finally Probability is the cost of the option divided by its return.

 Table 1

 The first thing about our simple model is that it makes sense. Intuitively, Wells Fargo and JP Morgan seem stronger at this point than either Citi or Bank of America. What is more interesting is that relative to Wells, both C and BAC offer approximately twice the odds of being taken over by the government. Further, JP Morgan appears to offer the safest haven among these mega-financial institutions. It is interesting to note, that as bad as the situation appears to be at both C and BAC, they are only 20% to 25% more likely to go under than Wells Fargo. If the financial sector stabilizes, these companies may offer significantly higher upside with marginally higher risk than Wells Fargo. Lastly, while our analysis is admittedly crude, it is clear that for C and BAC the odds of them getting nationalized are non-trivial and likely to exceed 25% to 30% under most reasonable models.