Now that LLOY has wriggled free of the APS and RBS has had no option other than to enter APS, there is uncapped upside in LLOY shares whilst RBS shares still remain effectively capped at 65 pence (due to the terms of the B shares).

Both LLOY and RBS have now sufficiently strengthened their Core Tier 1 capital ratios (to 8.6% and 11.1% respectively) for the market’s focus of attention to turn to recovery possibilities.  RBS have forecast losses for each of the three years 2009, 2010 and 2011 which will eat into their Core Tier 1 capital (and 59 pence NAV) and these losses also imply that RBS will not even start to redeem their outstanding £25.5 bln B shares until 2012 (and then it will probably take RBS at least three years to fully redeem the B shares as they have to be redeemed with fully-taxed profits).  Hence RBS shares are effectively capped at 65 pence until the middle of the next decade because if RBS shares trade above 65 pence then the 7% B-share dividend falls away.  In this case HMT would logically want to convert its B-shares into ords and sell them in the market to realise a profit for the taxpayer.  But £25.5 bln B-shares convert into 51 billion ordinary shares (vs 56.35 bln currently outstanding) and ordinary shareholders will not want to get diluted in this way.  This is a real obstacle in the way of RBS shares progressing above 65 pence anytime over the next 5 years (it is also noteworthy that RBS CEO Stephen Hester’s full £9.6 mln compensation package depends on RBS shares getting to 70 pence).   The only way around the 65 pence cap is for RBS to somehow generate £25.5 bln in Core Tier 1 capital in order to be able to redeem the B shares but launching a rights issue is not the solution as this too will dilute ordinary shareholders (as would a debt-for-equity swap).  RBS may be able to make some money by buying back more of their own debt at a discount but this will only generate a small fraction of the £25.5 bln needed to clear the upside for RBS ordinary shares.  In the meantime RBS are not going bankrupt but RBS shares only become worth buying if they fall back towards their 10 pence low seen in January 2009.

Investors in RBS should switch into LLOY and take up their rights.  There will be plenty of opportunity to bank profits in LLOY and rotate back into RBS over the next 5 years.

As for the other major banks, HSBC are profitable and as a result their Core Tier 1 capital ratio is creeping higher (now 9.0%), but their 80% loan-to-deposit ratio is very conservative.  BARC have recently reported a Core Tier 1 ratio of 8.9% but they seem to be mutating into a global investment bank.  Assuming (for simplicity) the LLOY £13.5 bln rights issue is 1-for-1 at 50 pence, then LLOY post-rights NAV will be approximately 90 pence.  This gives an idea of where LLOY and RBS shares will eventually end up as over the long term bank shares seem to range between 50% and 300% of book value. 

Post Script (7 Dec 2009) : The actual terms of Lloyds’ rights issue were set at 1.34-for-1 at 37 pence.  This results in a Net Asset Value of approximately 73 pence per LLOY share after the rights issue is completed.

One year on from the bankruptcy of Lehman Brothers and we have seen global stockmarkets spend six months plummeting to a low in March 2009 and then another six months rallying back again.  The Dow and S&P are now 15% below the levels at which they stood on the Friday before Lehman went bankrupt on the weekend of September 15th 2008.  The FTSE is just 5% below its close on the eve of Lehman’s bankruptcy.  We are still amidst the fog of war and nobody can quite work out whether stockmarkets are now too high following the impressive 50% rally since March or whether stockmarkets still have room to rally because an economic recovery may be starting (which then leads to an argument about whether the stockmarkets will fall again next year should there be a double-dip recession).

If we track back to the week before Lehman went bankrupt then stockmarkets had already fallen 20% from their highs in October 2007 and they were discounting some type of a recession and had not yet begun to rally in anticipation of an economic recovery.  The bankruptcy of Lehman changed the outlook so severely that markets sold off savagely to discount some type of 1930’s-style depression (with leveraged players being forced to liquidate which pushed share prices down even further).  The governments and central banks stepped in with some determined spending of taxpayers’ money and as the spectre of a depression has receded, stockmarkets have rallied back to their current levels (which are still below where they were on the eve of Lehman’s bankruptcy).

So have stockmarkets rallied too far or do they still have room to rally some more?

Although markets never move anywhere in a straight line, it feels as if they still have room to rally further as the tentative economic recovery which has begun goes on to establish itself more firmly.  Given that on the eve of Lehman’s bankruptcy markets had not yet even begun to discount an economic recovery then in order to discount whatever shape of economic recovery we are about to experience, stockmarkets should logically be higher than where they were in early September 2008.  The US and UK are likely to report positive economic growth for the quarter just ended when GDP data is reported for Q3 2009 and only time will tell whether they go on to report another quarter of growth in the final quarter of 2009 (see One Quarter at a Time).

So stockmarkets may well continue to climb the current Wall of Worry for the next couple of quarters and we can then start to consider the possibility of whether there will be a double-dip recession in 2010.  Although central banks continue to print money and interest rates will stay rooted near zero for a long while yet, a sense of normality is starting to return to corporate life with takeover activity returning to stockmarkets (Kraft/Cadbury and Balfour Beatty/Parsons Brinckerhoff being just two recent examples) and companies are finding it possible to raise equity capital (even though they are most unwilling to get deeper into debt).

Tentative it may be, but the recovery (which may well be long, slow & grinding) is only just beginning.   The fog will clear from the battlefield over the next few quarters and investors will be able to assess things more clearly.  The bad memories of the last year are still fresh in investor’s minds but stockmarkets look forwards, not backwards.

The Dow made it as far as 9,918 in the rally after the FOMC statement was released on Wednesday 23 Sep 09 before turning around and selling off for the rest of the week.  Does it matter that this rally off the March lows hasn’t made it all the way to the magic round number of 10,000?

The bears keep pointing out that the market is on too high a p/e ratio for a new bull market to be truly underway and therefore a big correction must be just around the corner.  However see “Is the Bear Market Over?” for the reasons as to why the Dow is unlikely to take out the 6 March 6,470 low.

The bull’s case can be summed up in a beguilingly simple way:  The Fed and the BoE are determined to keep interest rates close to zero and carry on printing money until a sustainable economic recovery is underway.  As it is the stockmarket’s job to discount the future then it doesn’t matter what the shape of the economic recovery is going to be (V, W, U or the more exotic Square Root sign), it is more important that an economic recovery is on its way and therefore the market will keep on rallying in order to discount the coming recovery and will continue to frustrate those people who are looking for a big pullback so that they can buy into the market.

The problem the bears have is that anyone disagreeing with the bullish argument above is essentially saying that the central banks are going to fail in their mission to reflate the economy and help an economic recovery to take hold.  There is a very old saying in the markets which goes “Don’t Fight the Fed”.

The central banks have more money than individual stock market participants and thus far the Fed has promised to print $1.75 trillion (they are slowing down the rate of spending as the economy appears to be entering a gentle recovery but rest assured, they will print more money if the economy stumbles again in 2010).  The BoE is set to print £175 billion and they are not slowing down the printing presses as the Governor would prefer to print £200 billion and then see how the economy is getting along.

Possible events which could derail the current rally include a sharp sell-off in the Government bond markets, the monoline insurers being downgraded, problems emerging in German banks once the 27 Sep elections are safely out of the way, Spanish banks admitting they are in trouble with their loans to property buyers and developers (how are the Spanish workers going to generate enough money to service their mortgages when nearly 20% of them are unemployed?) or the US economy slipping back into recession next year now that the boost to demand created by their “Cash for Clunkers” program has expired and especially if the Bush tax cuts are reversed at the end of 2010.  However for now these potential problems are hiding over the horizon and, with interest rates close to zero, the stockmarkets may continue to frustrate the bears and just carry on squeezing higher, climbing the “Wall of Worry”.  We have already had the “Dash for Trash” and therefore the next part of the rally will have to be led by the big quality blue chips.

A recession can be viewed as too little demand for goods & services (nominal GDP). One way for a country to bring itself out of recession is to depreciate its currency (which effectively moves GDP, via exports, to the country in recession from other countries, boosting the former’s GDP). However the problem with the current global recession is that this is not an option as there is too little demand for goods & services across the globe. A country cannot just devalue itself out of a global recession. Japan has just given us an excellent example of what happens when a country is too reliant on exports, as demand has contracted globally, Japanese exports have just fallen off a cliff (down nearly 50%) and Japanese GDP has contracted as a result (when the world finally recovers from this global recession both Germany & Japan are likely to try to grow the size of their domestic economies so as not to fall into this trap again). What is needed is for the global pie of nominal GDP to be expanded.
Welcome to Worldwide Quantitative Easing. If every major economy stimulates its own nominal GDP by convincing their independent central banks to print money and spend it by purchasing government bonds (the governments then spend the borrowed money on goods & services) then the result will be the desired expansion of the global pie of nominal GDP. The side effect is a round of currency devaluations which show up most noticeably against any country which doesn’t engage in QE (the Euro is leading this particular pack and the usually-conservative Swiss recently decided they did not want their currency to appreciate alongside the Euro so they intervened to lower the Swiss Franc against the Euro and embarked upon Quantitative Easing of their own to boost their GDP and underline to the FX market that they meant business). Also, as mentioned in Race to the Bottom (27 March 2009), real assets increase in value (as measured in fiat currencies) - admittedly real estate & equities are currently in bear markets but they won’t last forever, especially at this rate.
The question of whether the world’s central banks are capable creating just enough inflation but not too much can be left for a while.  The central banks will have to err on the side of creating too much inflation in order to be on the safe side – then they can rein inflation back in again by slowly taking the punch bowl away so as not to undermine the recovery.