Revisiting the Stress Test

Early this summer we raised a number of questions in our Summer Quiz.  The objective was both to enlighten and to help investors make wise investment decisions over the summer.  As we hoped, anyone who took the quiz seriously has had a profitable summer.  (We'll try to wrap up the answers and award the prize, since we are now beyond Labor Day).

In Question #7 we asked:

The government stress tests for financial institutions have something
called an "adverse scenario."  The conditions from that scenario have
already been met, or nearly so.  (True or False)

At the time we posed the question, there was a universal fixation on the unemployment rate.  This was the only readily measurable input, and it seemed artificially low.  It was pretty clear that unemployment was going to lag the rest of the economic recovery.  Meanwhile, the other stress test inputs were not very visible.  On a symbolic basis, it was bad politics from the Obama Administration.

This fact was widely known to anyone paying attention.  A month before our quiz, Tom Brown wrote as follows:

But
as unhappy as I am about the stress test, I’m even more shocked by all
the commentators who dismiss the test results because they believe it
wasn’t stressful enough. Some of these people simply believe
the U.S. economy is headed into a death spiral; no how matter how
bearish a given forecast is, they’ll tell you it’s not bearish enough.
Others have lately built a nice business for themselves by being
relentlessly, flamboyantly negative. Still others simply don’t know
what they’re talking about.  Let’s look at a few of these people have
had to say lately:

Brown went on to analyze several bank critics.  These were the people celebrated as "getting it right."  Brown pointed out that the loss reserves in the test were very aggressive.  His prediction of the result?

The
likely result of all this? Just as in the last recession, the big banks
will emerge overcapitalized, over-reserved, while their shareholders
have been unnecessarily diluted.  It’s a disgrace.

Other source fixated on the employment number in the stress test, ignoring the (more important) loss reserve inputs.  Despite their analysis, several of the big banks are paying back TARP funds.

What Happened?

Since our quiz on June 15th, the big banks are up about 30-35%.  Anyone who did the homework could have participated.  Meanwhile, there has been fresh news about bank failures and additional capital requirements for regional banks.  As part of our series about what to watch, we noted that bank failures are not an important economic indicator.  Many blogs enjoy reporting a few more failures each week, adding to the impression that this is significant.  There has also been news that regional banks may need to add capital.  Maybe so, but it is not the crucial point.

As Tom Brown wrote:

In
particular, in the latest quarter, the banks’ NCOs came to 3.16% of
loans, far short of the 4.16% laid out in the stress case. And as you
can further see, chargeoffs under the stress scenario won’t peak for
another three quarters, at which point they’ll top 5%.

He produced the following chart.

We remain very interested in when banks will be willing to do more lending!

A Crucial Question for Investors

A common theme among many pundits is to say something like "X was wrong on subject A, so why listen to any future predictions?"  Some of the more aggressive pundits extrapolate.  If an expert was wrong on "A" you should ignore him/her on "B".

That was the dubious logic for missing one of the biggest rallies in history.

A Dose of Reality

The subject really requires a more extensive article (forthcoming), but the stress test issue highlights the main theme.  Every time we cite Tom Brown we get critical comments, since he "missed it," while Meredith Whitney and others "got it right."

Predictions are not so simple.

Those who "called the crash" are not all geniuses.  The others are not all dummies.  Experts use widely varying methods.

The biggest investor mistake is chasing performance, thinking that someone has a hot hand.

We are about to see this play out in many sectors.  The stress test is a good example.

[Full disclosure — Our accounts hold GS, BAC, and held at various times, regional bank ETF's.]