Three Different Looks at Bank Stocks

Banks continue to make headlines.

First there's the public dispute between Treasury Secretary Timothy Geithner and European regulators about how best to try to regulate the banking sector.

For the sake of brevity, I won't go into all of the details here, but sufficient to say that (once again) the Americans do not agree with the Europeans.

Former IMF chief economist Simon Johnson has been harshly critical of U.S. banking policy for several years now, and wrote a book called 13 Bankers which essentially eviscerates everyone involved in the financial crisis of 2008.

He wrote a blog post today in the New York Times which continues this general theme of harsh criticism of Secretary Geithner. I am noting it here not necessarily because I totally agree with his thoughts, but rather to give an indication of just how hard the regulatory headwinds are beginning to blow:

Mr. Geithner’s thinking on bank size is completely flawed. The lesson should be: big banks have gotten themselves into trouble almost everywhere; banks in the United States are very big and have an incentive to become even bigger; one or more of these banks will reach the brink of failure soon....

...The right conclusion for Mr. Geithner should be: huge cross-border financial operations are immune from orderly resolution; such companies should therefore be run on a completely segmented basis, with separate capital requirements and no recourse to parent companies. Consequently, capital requirements should be much higher than currently proposed by any official, for capital is the buffer that stands between bad management decisions and taxpayer bailouts when bank resolution is not possible.
http://economix.blogs.nytimes.com/2011/06/09/the-banking-emperor-has-no-clothes/?src=tptw

Ah, you say, this is all very interesting, but what does it mean for my portfolio?

Here's a couple of videos that might help. The first is features former Morgan Stanley strategist Barton Biggs, who now runs a $1.3 billion hedge fund called Traxis Partners. I have long been a fan of Mr. Biggs, who is a very smart investor as well as a terrific writer.

He doesn't like bank stocks in here, believing that their book values are overstated. He does, on the other hand, like big tech companies, which I will discuss in my next post tomorrow:

http://www.youtube.com/watch?v=ItdINs92mGA&feature=player_profilepage

Finally, from Jim Cramer of Mad Money fame. I know, Cramer can sound ridiculous sometimes, but there was a time that he was a very successful hedge manager himself, and in this piece about bank stocks he makes some comments that I think make sense.

Unlike Mr. Biggs, Cramer looks at the stock charts of some of the big financial companies and concludes that they are "dead money" for a while. Yes, they could rally for a couple of days, but Cramer's view of the charts is that many of the stocks have broken down, and that they are closer to "value traps" rather than investment opportunities:

Jamie Dimon Takes On the Government

I've written several times over the past week about my concerns regarding big banks.

It's not so much that I think we're heading for a repeat of the credit crisis of 2007-08. I think that the aggressive Fed intervention in the capital markets has mitigated this risk.

No, the problem for the banks is more fundamental. First, loan growth remains tepid. True, some sectors - like small business lending - have shown some signs of life over the last few weeks. Overall, however, weakness in housing, and general caution in Corporate America, has left the banking system awash in liquidity, and a dearth of qualified borrowers.

The other potential problem is regulation. The final details are yet to be ironed out, but it currently appears that US banks in general - and money center banks in particular - are going to have to add considerably more capital cushion than is currently required.

If the banks are forced to increase their capital, this will almost certainly drive down returns.

This prospect does not make Jamie Dimon of JP Morgan happy. Mr. Dimon has been quite vocal recently with his dissatisfaction of the proposed changes in capital requirements. Since he is head of one of the largest banks in the world - and arguably the most widely followed - his comments have received widespread notice.

It's hard to know whether Dimon is simply posturing for negotiations that are currently occuring behind closed doors, or whether he has already lost the argument. Still, it is certainly worth following.

Here's an excerpt from a column from CNBC (via the blog Net Net):

... it seems that what provoked Dimon were recent signals from a Fed governor that the largest banks might face an additional capital surcharge, above and beyond the new capital and liquidity requirements agreed to last year in Basel.

At Basel, regulators agreed to more than double the minimum common equity requirement for banks to 4.5 percent from 2 percent, with an added liquidity buffer of 2.5 percent. That means banks will have to have total risk reserves of 7% of weighted assets. Regulators did not reach a consensus on proposals for an additional buffer—or "surcharge"— for "systemically important financial institutions"—which is regulator speak for Too Big To Fail.

Many of the largest European and American banks have been lobbying hard against the new surcharge, but these efforts appear to be failing.

http://www.cnbc.com/id/43325105?utm_source=twitterfeed&utm_medium=twitter

Time to "Party" Like 1937?

Most strategists have been relatively sanguine in their comments regarding the recent string of weak economic data. The stock market has also been weak, but this is not totally unexpected after a strong first quarter.

After all, we saw the same pattern last year - a good start to the year, a mid-year pause, then a strong finish.

However, as also I noted yesterday, the people closest to the economic data are worried. It's not so much that May's employment report was well below expectations - after all, it's only one month - but rather the trend of economic reports is unmistakably lower.

The difference between 2010 and this year is the tone in the political debate. Fiscal policy discussions are mostly focused on how to cut spending, rather than new federal programs that might help job creation.

Fed policy is also unlikely to be as friendly as last year. The financial system is already flooded with liquidity, and lower interest rates appear to have had only a minor impact on interest-sensitive areas like housing.

Last year, stocks moved sharply higher with the added stimulus of the Fed's QE2 (remember Bernanke's editorial in the Washington Post advocating high stock prices?). In addition, Congress passed a number of tax incentives at year-end designed to bolster economic growth.

At the time, economists were falling over themselves to raise economic forecasts. This optimism now appears to have been premature.

Now, in mid-2011, it seems more likely that the government will slash spending in an effort to reduce the federal deficit. And judging from comments from Fed officials (other than Bernanke), there seems to be more internal debate about the need to raise interest rates to head off a possible surge in inflation rather than continue the current accomodative policies.

If this becomes the direction of government policy, I will need to seriously re-evaluate my current bullish stance on stocks.

The best analogy can be found a couple of generations ago, in 1937-38.

Paul Krugman writing in the New York Times last Friday had a good piece about the parallels with 1937. Here is an excerpt from his piece:

Earlier this week, the Federal Reserve Bank of New York published a blog post about the “mistake of 1937,” the premature fiscal and monetary pullback that aborted an ongoing economic recovery and prolonged the Great Depression. As Gauti Eggertsson, the post’s author (with whom I have done research) points out, economic conditions today — with output growing, some prices rising, but unemployment still very high — bear a strong resemblance to those in 1936-37. So are modern policy makers going to make the same mistake?

http://www.nytimes.com/2011/06/03/opinion/03krugman.html

And here's what Fortune magazine writes earlier this week:

As the Eggertsson paper notes, the Fed's fearful tightening in 1937 halted a recovery that had taken years to develop and dealt sharp blows to employment and production (see chart, above right). A premature response to the next energy shock could surely do the same to the current economic upturn, as shallow as it now appears.

Why the Fed will repeat its worst error - Term Sheet

Is the Economy Faltering? The Trend is Not Great

Years ago, when I attended the University of Michigan, I had the chance to hear Paul McCracken speak.

Mr. McCracken had been chairman of the Council of Economic Advisors under President Nixon. He also served as an economics advisor to Presidents Kennedy, Johnson and Ford. In other words, he was a important player in developing economic policy throughout the 1960's and 1970's.

It was a real treat for a fledgling business student like me to hear from someone like Paul McCracken, so I remember his talk to this day.

One of the main things I recall was McCracken's distrust of economic forecasting, in particular econometric modeling. Instead, to get some sense of the health of the economy, McCracken used to wander down to the department where they actually compiled the data.

McCracken said that the folks that compiled economic data from a wide variety of sources were usually the best equipped to judge economic trends, since they spent most of their working hours gathering and preparing reports.

I remembered Professor McCracken's words this morning, when I read an article in the Financial Times that highlight the concerns that Keith Hall, commissioner of the U.S. Bureau of Labor Statistics, raised about the recent trends in economic data.

In particular, the jobs report last Friday was dismal. The U.S. only added 54,000 jobs in May, well below this year's average gain of 182,000. While it is only one month, the overall trend is well below what one would like to see in an improving economy.

Here's an excerpt:

Some analysts suggest that the {employment} slowdown might reflect supply chain disruptions or extreme weather events such as the tornadoes that hit the U.S. in May, rather than any deeper slowdown.

But Mr. Hall said this is hard to see in the data. "There was really no jump at all in people reporting work disruption. So whatever has happened this month is probably not a weather effect."

FT.com / US / Economy & Fed - US data chief warns on employment

Many Wall Street analysts have been quick to point out the similarities between this year and 2010. Last year, the economy also showed signs of faltering in the spring, yet we ended last year on a fairly strong note.

However, I worry that this year might be different.

Last year's fourth quarter growth spurt was helped by a number of factors that probably will not be repeated this year.

In particular, the second attempt by the Fed to lower interest rates was announced in late August, and asset prices jumped. In addition, in the aftermath of the November elections, Congress passed a number of tax cuts which were intended to spur consumption and investment.

This year, however, the mood in Washington is different. I doubt that even Bernanke has enough political capital to begin a third round of quantitative easing. And with most of the tax in Congress about cutting spending, and raising taxes on wealthier Americans, it is hard to see a significant dose of fiscal stimulus any time this year.

And so I am heeding Professor McCracken's words, and focusing on what the data is telling us.

Bullish on Bank Stocks: A Contrarian View

Yesterday's note discussed my current dilemma regarding investments in bank stocks.

As you could probably tell, I am leaning towards reducing my positions in the financial sector, despite the fact that financials represent about 15% of the S&P 500.

As luck would have it, Jason Goldberg from Barclays was in town yesterday. Jason has followed large-cap and mid-cap banks for a number of years now, and is a first-rate analyst.

Unlike the consensus - including me, perhaps - Jason is a raging bull on the banking group, and believes that today's prices represent an opportunity for investors with a longer term time horizon to make some serious gains.

Jason acknowledged that he has never seen sentiment so negative towards his group. Everywhere he goes, he said, investors can list a number of reasons why they don't want to invest in bank stocks.

Although regulatory pressures could potential hurt the group (especially if banks are required to hold more capital), by far the most common concern is around tepid loan growth.

However, concerns about slow loan growth do not square with recent data.

For example, loan growth over the last few weeks has been ahead of the pace of the first quarter of 2011, according to the Federal Reserve.

As the brokerage firm Jeffries noted in a recent report, Commercial & Industrial loans increased +1.3% over the last 6 weeks. C&I growth was +0.7% in the first quarter of 2011.

Then there's valuation.

Jason noted that a couple of banks - Bank of American and Citigroup - are trading below tangible book value, and other banks are trading at the "cheaper" range of their historic valuation. At the same time, earnings reports for most banks have been actually pretty strong.

So what will it take for the bank stocks to start behaving better?

Jason went back to last year, when banks languished for most of 2010 and then rallied strongly into the close of the year. The bank stock surge at the end of the year was mostly the result of a sense that economic growth in 2011 might be better than anticipated, and that banks might actually show better earnings than Wall Street forecasts.

Now, however, the economy appears to be weakening again.

It is not clear whether this is a temporary phenomena (we had a similar economic pause in the early summer of 2010) or whether we are dangerously close to a more prolonged slowdown.

But I still conclude with the same observation as yesterday: if you think this is just a pause in economic activity, now is the time to be buying financials.

On the other hand, the more bearish view would of course lead you to the opposite conclusion.

What To Do With Bank Stocks Now?

Financials were crushed yesterday.

The weak housing numbers, and growing evidence that the economy is slowing at least temporarily, is causing investors to move to other, more defensive sectors.

I have been generally cautious on the financial group. The debt that was created in the housing boom years of the last decade is unfortunately still lurking on bank balance sheets.

With house prices declining in most parts of the country, and real income growth a challenge for most American workers, it will probably take years before the housing market returns to normal.

I last tackled this question in January 2011 in Random Glenings. Here's an excerpt from what I wrote then, with the full link below:

Anemic loan growth; unrecognized loan losses; low interest rates; and possible "irrational exuberance" about future prospects - all should add up to a group that should be avoided.

And yet the financial sector has been on a tear over the last few months, boosting the returns of the S&P. Bank stocks in particular outperformed the market in December by 800 basis points. Woe to the equity manager that is either underweight or avoids the group.

So now my colleagues and I have to figure out what to do.

http://randomglenings.blogspot.com/2011/01/what-to-do-with-bank-stocks.html

What we did, earlier this year, was add slightly to our financial weightings mostly through the use of the Financial Sector exchange-traded fund (XLF). This allowed us to get closer to our market benchmark (the S&P 500) but spread our risk among a basket of financial companies.

Now I am wondering if we should cut back again, but wondering if all of the "bad news" is already in the financial stock prices.

For example, CNBC had a piece which indicated that many hedge funds have been large sellers of bank stocks:

After making a killing buying the big banks at their nadir, savvy investors are moving on. Bank stocks are still cheap, but investors expect lackluster revenue growth and new regulations to keep prices depressed for some time.

"Financials have become hated in recent months," said Alan Villalon, a senior bank analyst at Chicago-based Nuveen Investments, which owns bank stocks

http://www.cnbc.com/id/43147574

If you look at the bank stock universe in general, most are trading at a valuations that are about in the middle of the range of the last 5 years. This would seem to suggest that if one wanted to cut their financials position, it's not too late.

Valuations aside, it seems that the decision of whether to sell financial stocks or not is largely a market.

Ned Davis of Ned Davis Research (NDR) noted in a research piece a couple of weeks ago that financial stocks typcially begin to deteriorate 7-8 months, on average, prior to a stock market peak, based on the last ten NDR-defined bull markets since 1976.

Mr. Davis went on to say:

What bothers me about the Financials, beside their leading tendencies and connection to the debt bubble, is that all of this poor action has come after the massive stimulus by the Fed and the government to help this sector get bailed out from its own mistakes. Profits are up, and the Financials have been allowed to hide their toxic assets by not marking all their assets to real market prices, and the Fed has made the yield curve so wide that the banks are minting profits...Yet the banks are still underperforming.

Lots to think about this morning.

I Know I Was Looking for Lower Yields, But This is Ridiculous

I have been writing on this blog for last year or so that I expected interest rates to move lower, not higher.

This has been a decidedly out-of-consensus view. Most commentators and investors were convinced that rates were headed higher, including one of the best bond managers of our generation, Bill Gross of Pimco.

So what's happened?

Rates are plunging lower. At this writing the 10 year Treasury is yielding less than 3%, down nearly 75 basis points from just 4 months ago. The 2- year Treasury note offers a whopping 0.48%.

Corporate and high yield debt yields are also moving lower. Yesterday's Bloomberg pointed out that for the first time since 1987, the earnings yield of the S&P 500 is higher than the average yield on junk bonds, according to Barclays.

Investors and savers are dying for yield, and yet there is little to be had.

All of this is happening against a backdrop of considerably improved economic conditions than 2 years ago. Most corporations are reporting good, if not, record earnings, despite tepid top line growth. Stocks have nearly doubled since the lows of March 2009.

Still, rates are moving lower because housing prices are moving sharply down, and the economy is showing signs of slowing.

Low interest rates, at some point, become a curse, not a blessing.

Or, to put it another way, I kinda wish that I had been wrong on rates, and that the so-called bond vigilantes had pushed interest rates higher.

I manage a number of balanced portfolios for clients, using a combination of stocks and high quality bonds. The idea of bonds in these accounts is to provide some measure of protection, and hopefully some modest degree of income.

Problem is, that if interest rates don't move higher soon, it will be harder to maintain a significant weighting in bonds.

One of the best alternatives to bonds, it seems to me, remains large cap, dividend-paying common stocks. True, stock prices can be volatile, but it seems reasonable that the value of most stocks will be higher 5 years from now than they are today.