Wednesday, October 26, 2011

More on Bank Stocks

We had a long and heated discussion here at the bank this morning about investing in the financial sector.

The S&P 500 has slightly more than 13% weighting in the financials. Underweight the sector in client portfolios, and financials rocket ahead like they did at the end of 2010, your relative performance suffers.

On the surface, the group looks incredibly cheap. The money center banks in particular are trading at a price/book ratio not seen in 30 years, so it would seem that they are ripe for investment opportunity.

But not to me.

Yes, I recognize that the problems of the financial sector are widely known, and that any "good news" from Europe could cause the group to soar.

Moreover, if the glimmers of economic resurgence continues, financials historically have done very well when economies are healing.

My main problem with the group relates in part to the post from yesterday about Ray Dalio. Dalio's company Bridgewater Associates focuses on what they don't know as much as what they believe, which is an approach I favor as well.

So, what is it that we don't know about the financial sectors health?

Plenty, I would argue.

For example (quoting from Monday's Financial Times Lex Column):

Try this on your credit card company: your creditworthiness has weakened, so you write down the value of what you owe to reflect the greater risk that you will not pay it all back and credit the difference to your personal account. That is exactly what accounting allows; the top five big US banks - Citigroup, Bank of America, JP Morgan, Morgan Stanley and Goldman Sachs - have just reported gains equivalent to more than four-fifths of their quarterly $16bn net profit as a result of falls in the value of their own debt and credit standing. Now European banks are set to report with the same system.

Bank of America reported reasonably good earnings last week - until you stop to consider that it needed 15 separate "one-time" boosts to get to a reasonable earnings number.

This, by the way, was on the heals of the 16 different "one-time" boosts that BofA employed in the second quarter.

So, in fact, we really have no idea what banks are even making.

Then there is the simple problem of low interest rates. Banks typically make a good chunk of their earnings from the spread between short term and long term interest rates. However, with loan demand tepid, and rates on Treasurys at 1% or less on all but the longer maturities, there is no spread available.

This becomes particularly important to banks at the present time, when they are being inundated with deposits. As Monday's New York Times pointed out:

Normally, banks earn healthy profits by taking in deposits and then investing them or lending them out at substantially higher interest rates than what they pay savers. But that traditional banking model has broken down...

Today, banks are paying savers almost nothing for their deposits. As it turns out, the banks are not minting money on those piles of cash. Lending levels have not bounced back from only a few years ago and the loans going out are not keeping pace with the deposits rushing in.

And what do we know about the quality of bank balance sheets? Nothing. Banks have been reluctant to write down non performing loans since they do not want to recognize losses.

In short, we don't know what banks are actually earning, nor do we know anything about credit exposure. With the economy mired in de-leveraging mode, prospects for loan growth do not seem promising.

So what is the catalyst for bank stocks? I'm hard pressed to find one, but I will continue to look.

One final point: one of my fellow managers kept insisting that "everyone" is bearish on the financial sector, and banks in particular. He concludes that the contrarian play, then, is jumping back in the sector.

However, financials still represent the second largest sector weighting in the S&P index, despite massively underperforming the rest of the market this year.

The stock market that by definition has to have a buyer for every seller, there apparently are still lots of folks that believe that the banks are about to turn.