July 6, 2016

Now may be a good time to cut down on Long Bank stock positions

Let's start the day by talking about why I'd suggest using bank stocks' current strength to sell or reduce your exposure to the sector.

Now, my background and "street cred" in the banking industry runs deep. Back in the early 1970s when I was one of Ralph Nader's "Nader's Raiders," I helped Nader and the Center for the Study of Responsive Law author the book Citibank.

Several universities used the tome as a banking textbook. For example, my sister Barbara read it as part of her banking class at the University of Wisconsin. 

Later, I covered banks, thrifts and GSEs for Putnam Management in Boston in the mid- to late-1970s after I graduated from Wharton with an MBA. Institutional Investor magazine voted me the buy side's No. 1 bank-industry analyst, and I've been trading and investing in banks stocks ever since.

I bought a basket of bank stocks on Monday, purchasing longs of Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase and Morgan Stanley. However, this was a trade rather than an investment, and I sold the stocks after the banks saw about a 10% increase in just two days.

I'd say that you should consider paring down any bank-stock positions as well, based on the sub-optimal regulatory and fundamental outlook that I see for the sector's 2016-17 profits. I also see numerous other headwinds to adequate (and historical) returns and valuations, including:

Overly Optimistic Earnings Estimates

I believe that analysts' consensus earnings-per-share predictions for 2016-17 are too high.

After all, I think bank profits are exposed to foreign-exchange losses, low absolute interest-rate levels, an ever-flattening yield curve and high restructuring charges (principally related to Britain). I also think capital markets could be moribund in 2016's second half, contributing even further to profit weakness.

High Regulatory and Compliance Costs
These expenses will remain elevated, and a possible Democratic presidential win will likely further raise non-core expenditures.

Fewer Jobs to Cut
The banking industry has been cutting its way to profits by eliminating jobs.

However, there's a limit to how long you can do this, and most banks are quite lean now.

Stress Tests That Don't Matter Much
Financial firms extended their upward move into after-hours trading yesterday following the Federal Reserve's release of mostly positive bank "stress tests."

However, this might have just been a short "relief rally," as the results came in materially in line with expectations and the pro-forma dividend yields that passing the test allows banks to provide will give the sector only limited support.

Also bear in mind that the banks have essentially "reverse-engineered" their stress-test results, and that it gets easier and easier to pass the Fed's review over time. It's as if you took the SAT every year -- your results would likely improve as time went by.

That's exactly what's happening with the stress tests. Passing them is no biggie, but the markets are ecstatic (for now).

Buybacks That Don't Matter Much
While banks have increased share buybacks, that's been in line with forecasts and not appreciable in an absolute sense (and relative to shares outstanding).

Besides, haven't we learned from Apple (AAPL) and other stocks that buybacks and return of capital aren't the sine qua non?

Counterparty and Contagion Risks
As I discussed in Is Deutsche Bank the Canary in the Coal Mine?, the European banking industry is weakening -- exacerbated by the Brexit vote, which only reinforces deflationary fears and pressures.

This presents U.S. banks with counterparty and contagion risk. In fact, I'd go one step further and say that heavily leveraged Deutsche Bank (DB) and its frighteningly enormous derivatives exposure single-handedly represent an even greater systemic risk than AIG (AIG) did 10 years ago.

Unimpressive Return on Capital
Banks use 8% ROIs to justify what many view as inadequate and inexpensive valuations. But the above market and regulatory headwinds mean that many firms produce what I think are inferior returns on investment capital.

The Bottom Line

The banking sector is one of the few market segments that I have a broad knowledge of.

Of course, I'm never self-confident of view, and my base of understanding doesn't guarantee that my judgment about the group will be correct. But I believe that my background with banking puts me on terra firma here