Doug Kass shares his views every day on RealMoneyPro. Click here for a real-time look at his insights and musings.
Why I'm Not Banking on Banks
Originally published June 30 at 8:50 a.m. EDT
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. (Citi CEO Walter Wriston later had the book Citibank, Nader and The Facts published in response.)
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 (BAC) - Get Report , Citigroup (C) - Get Report , Goldman Sachs (GS) - Get Report , JPMorgan Chase (JPM) - Get Report and Morgan Stanley (MS) - Get Report . 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).
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) - Get Report and its frighteningly enormous derivatives exposure single-handedly represent an even greater systemic risk than AIG (AIG) - Get Report 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.
Position: Short AAPL (small).
Originally published June 29 at 8:25 a.m. EDT
Expect the Unexpected
"Mankind is facing a crossroad -- one road leads to despair and utter hopelessness and the other to total extinction. I sincerely hope you graduates choose the right road." -- Woody Allen
Britain's Brexit vote was unexpected, and so was the swift recovery in stocks yesterday from the worst two-day decline in nearly a year that followed the decision. (The rebound is continuing so far this morning, with the S&P 500 futures about +12 at last check.)
As I wrote yesterday in What I Told Jim Cramer, I didn't join the chorus two days ago of those making of near-term 1,900 forecasts for the S&P 500. Instead, I covered many of my shorts and purchased a basket of long rentals, with an emphasis on the depressed financials -- Bank of America (BAC) - Get Report , Citigroup (C) - Get Report , Goldman Sachs (GS) - Get Report , JPMorgan Chase (JPM) - Get Report and Morgan Stanley (MS) - Get Report .
Trading Mission Accomplished
I don't think that this mini-rally is the start of a new bull-market leg. Instead, I continue to believe that stocks are in the process of making a major, important market top that began in May 2015.
So, I expect to sell off my long rentals (taken out in the teeth of the downside move early Monday afternoon) as the S&P 500 moves quickly back toward my 2,050-2,075 near-term price target. I already sold my long rental of the SPDR S&P 500 ETF (SPY) - Get Report Wednesday morning for close to a $5 gain from my purchase price (which was under $199.50).
I also intend to sell my financial long rentals without waiting for the upcoming news about the banking industry's "stress tests." After all, the financials have moved mightily higher from Monday's lows. All told, I plan to exit all of my trading longs this morning except for my stake in the ProShares UltraShort 20+ Year Treasury (TBT) - Get Report .
Given the many possible economic and market outcomes -- many of them adverse -- I'm reluctant to make big bets regardless of whether my views are bullish or bearish. Instead, I'm sizing my positions accordingly, as I respect the fact that our market moves without memory from day to day.
The Uncertain Journey
"Float like a butterfly, sting like a bee. His hands can't hit what his eyes can't see."
-- Muhammad Ali, before fighting George Foreman in 1974
As I wrote yesterday, I don't believe it's easy to predict the market's short-term destination, as machines and algos complicate the picture and render charts less precise as predictive tools.
In fact, I'll go one step beyond that and write that the more self-confidence that people express in their market views, the less accurate they're likely to be. I wear my market insecurities on my sleeve (and in my pen!).
I don't believe that anyone should encase their short-term forecast in confidence, and I size my trading and investing positions accordingly (i.e., small).
Yesterday's terrorist attack at Turkey reminds us to always expect the unexpected, and that we as citizens and investors aren't as safe as the markets assume. Traders are investors are becoming callous to such events, but geopolitical risks are rising and provide a headwind to the markets (and possibly even to global economic growth).
Given Tuesday's outsized market advance and another strong rise in the futures this morning, I expect to retreat back to market neutral today from my current, slightly net long exposure.
Also note that tomorrow marks the end of both the month and the quarter. As such, I expect an imbalance of stock-buying and bond-selling tomorrow afternoon given bonds' recent strong performance relative to equities. In fact, some of yesterday's stock rally could have been in anticipation of this, so I'm not going to wait in paring down my trading longs.
Over the longer term, I still expect the S&P 500 to record a high-single-digit decline this year, with both the May 2015 top and last week's near-peak (2,113) going untested during the rest of 2016.
Position: Long TBT (small), C (small), BAC (small), JPM (small), SPY (small), GS (small), MS (small).
At the time of publication, Kass and/or his funds were long/short XXX, although holdings can change at any time.
Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.
Action Alerts PLUS, which Cramer co-manages as a charitable trust, is long C and AAPL.