Note: I am going to be playing catch up here for a while since I have been away from my computer for most of the week. So this is the first in a series of post reviewing what the US political elections mean for the economy and markets. I want to make these posts modified daily posts, meaning I will focus on a single issue and direct you to a few other posts elsewhere that give you a fuller picture of that same issue.
The first post here is about bank stocks, bank regulation and the election of Elizabeth Warren.
After the market bottomed in March 2009 and mark to market rules in the US were relaxed, I became very bullish on financial stocks. While I believed that the stock and economic rebound would represent a “fake recovery”, I felt nonetheless that financial stocks would do well. Underneath the cyclical uptick was a much less bullish fundamental picture. As Warren Buffett recently noted, banks’ pre-crisis 25% return on tangible equity was a “crazy number”, completely unsustainable over the longer-term without increasing leverage and risk. The financial crisis has ended that game and we are now entering a period in which banks will need more capital, take on less risk and have less leverage. This automatically implies lower returns, lower earnings growth and lower price/earnings multiples. So after the initial bounce off March 2009 lows, I turned bearish on large cap financials in October 2009. Indeed, this sector plateaued at just this time and has since trended down.
The experience here has left me with the impression that sector rotation is an important aspect of getting this cyclical bull market right, as various market sectors and asset classes have powered ahead as the uneven recovery has progressed in the US.
I should also point out that banks have been under-reserving as banks’ accounting gains have been driven by a reduction in loan loss reserves. Analysts like Jeffrey Gundlach, John Hussman and Meredith Whitney have made this connection in the past. Whitney believes that the recovery for banks is driven by a two-stage process of asset write-ups buttressed by rising asset prices and the end of mark-to-market accounting followed by the large reductions in loss-loss reserves I just noted.
Moreover, bank net interest margins are increasingly negatively affected by the Federal Reserve’s seemingly permanent zero interest rate policy. Even the relatively robust super regional bank cohort that includes franchises like M&T, BB&T and US Bank is being negatively impacted by lower net interest margins.
My conclusion: we saw the maximum gains for bank stocks after the March 2009 rebound. The bank sector will continue underperform despite the cyclical upturn because the fundamentals for the sector are weak.
This brings me to the regulatory environment, which is certainly more strict for banks. If you listen to bank industry executives, you would believe that it is regulation that is holding back the sector. But the purpose of regulation is to prevent another systemic bank crisis and people like Elizabeth Warren are going to be instrumental in pushing this agenda. After the election on Tuesday, the market was down and bank stocks were notable losers as Warren was elected to the US Senate. I believe Warren’s election is a net positive for reducing systemic risk, but it is indeed a net negative for what it represents: a new more hawkish regulatory environment for banks in the US. The Obama Administration is still relatively bank-friendy. When Tim Geithner leaves the administration, he is likely to be replaced by another bank-friendly Treasury Secretary like Erskine Bowles, whose name has been prominent among contenders. Even so, I still believe the regulatory environment for banks has changed and will be stricter for a long time to come. While that is good for the overall economy – and bank stocks in one sense – it means a lower return on equity and a reduction in the option value that too big too fail represents. That’s bearish for banks, which I continue to believe should be underweight in one’s portfolio. To the degree one wants US bank stock exposure, the super regionals are still the best bet.
Related articles:
“The chances are good, but not guaranteed, that Elizabeth Warren will secure a highly coveted seat on the Senate Banking Committee, a move that would dramatically elevate her campaign against Wall Street excess.”
“One of the most important results on Tuesday was the election of Elizabeth Warren as United States senator from Massachusetts. Her victory matters not only because it helps the Democrats keep control of the Senate but also because Ms. Warren has a track record of speaking truth to authority on financial issues – both to officials in Washington and to powerful people on Wall Street.”
“my bet is that Warren will use her newly minted Senate platform to continue her demonstrated commitment to being a loud and passionate advocate for those whose voice is often not heard in Washington, even if it means offending the sensibilities of some of her new colleagues.”
“Democrat Elizabeth Warren, whose attacks on Wall Street helped fuel her political ascent, became the first woman elected U.S. senator from Massachusetts by ousting Republican Scott Brown.
Warren beat Brown 54 percent to 46 percent in one of the most bitterly contested Senate contests of the year, AP reported. Polls taken before the election had shown Warren with a lead over Brown of 4 to 6 percentage points.”