I like looking at financials for two reasons. First, they are very indicative of the economy. Their exposure to residential and commercial real estate, credit and capital markets are all mirrors of our economy. Second, the financials will move with the markets, and the long-term thesis remains: over the next 3-5 years, I believe that the financials will offer substantial returns for investors.
The real question is how to handle the short-term. Over the next couple weeks, a correction, probably in the 10-20% range, is likely. Of course, such a correction needs to be confirmed by follow-through (several consecutive down days) and can depend greatly on data, such as unemployment reports (the next is Friday, September 3, 2009). Still, if it occurs, such a correction would actually be a good thing: it allows financial stocks to regroup and continue moving forward.
Personally, I plan to buy into the correction. To be clear, I’m not saying that it’s all clear in the financials, not by any means. As investors, we have to watch out for events or news that could turn stocks in one direction or another.
So here are the things I’m looking at. First, let’s take a look at the capital markets operations – the investment banking side of the equation. This applies to the pure plays – Goldman Sachs and Morgan Stanley, as well as the banks with substantial investment banking operations: Bank of America, Wells Fargo, JP Morgan and even Citigroup.
Over the next couple quarters, investment banking operations should continue to bring profits. In part, the investment banks should do well just because there are now fewer of them. With the fall of Lehman and Bear Stearns and to a certain extent, Wachovia, investment banking business falls to the few remaining players. Meanwhile, trading in government securities, corporate bonds and high yield debt remains very strong. Equity underwriting remains slow, and those that have retail brokerage operations and asset management divisions will see some weakness there. Still, propects remain good here. And, the government continues to support profits in this sector. This all bodes well for Goldman Sachs, Morgan Stanley (to a lesser extent, because it is less aggressive than Goldman), and the investment banking divisions of the banks.
Greater questions emerge in the last quarter of 2009 and going into 2010. Eventually, government support will have to be withdrawn, and if substantial profits are reported through year-end (already, there’s talk that 2009 might be a very strong year for bonuses at Goldman Sachs), withdrawal of support becomes more likely. A tightening of interest rate spreads may also make it harder for these companies to finance their operations. And if the second half of the double dip occurs, trading, debt and government securities operations may very well slow. Remember that in 2009, the investment banks will benefit from companies re-capitalizing their balance sheets and credit markets returning. Much of that may fall away in 2010.
For the more traditional banks, the picture is more serious and I believe that the possibility of a double dip is fairly strong. 2009 has been an usual year because of the need to stabilize the banks. As we go into 2010, the Fed will feel the need to start withdrawing support from the system. Truth be told, the Fed probably wants to support the banks for a long as possible, but I suspect that there will not be the political will to do so because everyone believes the crisis has past. And Washington does not work well without a crisis.
On the economic side, all indications are that foreclosures are now affecting the prime and jumbo market, and these are mortgages that can’t be worked out because these homeowners are having trouble paying their mortgages (due to job losses, etc.). Reports this week say that the number of homes in foreclosure are increasing, not decreasing. Commercial real estate is also beginning to hit the point where they have to be dealt with, and so that will be another hit to the banks. In 2009, banks have delayed recognizing losses by trying to work them out, providing extensions and so forth. We will soon reach the point where delaying tactics won’t work anymore; it will be time to face the music.
Other macro factors will test banks. Eventually, the Fed will have to start exiting the quantitative easing strategy. That means interest rates may start to rise and banks will not benefit from the fat spreads that they’ve seen in the last year. Foreign banks may very well slow their purchases of US debt, and inflation may also start to rear it’s head.
All in all, there are several reasons to be concerned about the banking sector going forward. So what would be the game plan? I still like Goldman Sachs and Morgan Stanley to a lesser extent, especially if their prices dip because of a correction. For the banks, I plan to buy the next pullback, but with two qualifications: much depends on the individual bank, and these banks have to be owned with a careful eye to the obstacles mentioned above. JP Morgan remains the strongest; Wells Fargo has great earnings power but needs to figure out how to pay back TARP; US Bancorp is solid, well managed bank, but has lending exposure; Bank of America and Citi are interesting but risky because their balance sheets are weaker. All can are subject to the headwinds mentioned above, so if things start to turn the wrong way and we get the second half of a double dip, it may mean stepping out and then stepping back in later.
For those that don’t want to trade in and out, I still think that dollar cost averaging, or buying on pullbacks, remains the best strategy. For example, if you are conservative and don’t want to spend too much time watching the markets, you could buy JP Morgan on dips, and dollar cost average if we enter the second half of the “W” recovery. This will give you a lower cost, and JP Morgan will probably emerge as a very strong bank in 3-5 years with most of its troubled assets off its books. This is a conservative, long-term strategy that has a strong probability of working.
For the regional and smaller banks, these are more-lending based, and so they are exposed to all the headwinds mentioned above without the benefit of diversification into the capital markets. Most analysts expect as much as 500 more banks to fail by the time this is all over. For me, this is a steer clear area, or a lot of work to make sure a smaller bank is a good investment.
All in all, the entire banking sector still faces challenges ahead. But for the patient investor, that could very well mean opportunity.
I am long Goldman Sachs, Morgan Stanley, JP Morgan, US Bancorp, Bank of America and Citigroup. I have no position in Wells Fargo at the current time.
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