"It's morally wrong to allow a sucker to keep his money"
-- W.C. Fields
Cramer: Surviving Banks Aren't Sure Buys
Although all of these institutions will be supported by government intervention and are likely to gain market share, that doesn't mean their stocks are a good investment. The fundamentals of the banking business and how banks make money have been shattered. Securitization is nearly dead, with no rebound in sight. Prime brokerage and hedge funds, which were major profit centers for the investment-banking sides of firms like Goldman and JPMorgan, are in a severe decline, as are stock and bond underwriting. Wealth management has held up reasonably well, but with all of the wealth destruction going on in the world right now and increasing risk-aversion, it doesn't appear to have a very bright future. Forced deleveraging and increased regulation will further diminish bank profitability from other higher-margin, and riskier, activities such as proprietary trading and derivatives. What about good old-fashioned lending like in Frank Capra's It's a Wonderful Life? One of the dirty secrets is that banks don't make much money on good old-fashioned lending. It is a business that wouldn't make any sense without the massive leverage and subsidized cheap money from the government. It is a low-margin and high-cost business that is also vulnerable to the economic cycles, as we have seen recently in the extreme. Also, with banks facing potential further writedowns and realized losses from foreclosures, higher regulatory capital requirements, and weak loan demand from increasingly reluctant borrowers, even the traditional lending business faces many headwinds. When would I buy banks stocks? I would wait until two things happen. Home prices need to start increasing. This is the only way that bank balance sheets will really improve without further dilution from capital raises that harm shareholders. I don't expect that to happen for a couple of years. Also, regulators need to start easing up on banks by allowing them to reduce regulatory capital requirements and take more risk. I don't expect that to happen for more than a decade. If anything, regulation of banks is going to get worse for many years. This will hinder the profitability of banks for a long time, so I am not eager to look at buying bank stocks for many years. What about the attractive dividend yield of many banks? My view is that buying an extremely volatile, highly leveraged and economically cyclical stock for a single-digit dividend yield is the ultimate sucker's bet. If you look at the food and drug stocks, many of them have similar dividend yields, but those companies are far less volatile, are not economically sensitive and are conservatively leveraged. Also, if you just want yield and income, you could also take a look at municipal bonds. Because of the recent turmoil in the financial markets, many tax-exempt bonds with AAA and AA ratings are trading at competitive yields with bank, food, and drug stocks. With muni bonds, you don't have to pay taxes on those yields, and those bonds are backed by state and local governments with the power to raise taxes. Obviously, companies cannot pay their dividends by raising taxes.
What about diversification? Shouldn't everyone own financials in a balanced portfolio? My view is that diversifying your way into probable losses or lousy returns doesn't make sense. However, I do recognize that most people feel naked without a properly "balanced" portfolio. If you feel like you have to own some financials, I would look at the preferred stocks of the strongest banks, such as JPMorgan or Wells Fargo. They are probably your best bet in financial stocks for not losing money and probably making a decent dividend yield. Why not short financials either through individual stocks or by shorting the Financial Select Sector SPDR Fund ( XLF) or some other financial ETF? First of all, the government has made it very difficult to short-sell financials. Second, my view is that shorting is only for professional traders who have done extensive independent due diligence and are constantly monitoring their positions. Third, since many bank stocks have already declined substantially, shorting has limited upside. It is much wiser just to avoid the financial sector and find better long-side opportunities elsewhere. My view is that most readers, especially in challenging economic times like these, should emphasize liquidity and safety over thoughts of potential future upside. As I have explained, investors have much better alternatives to find attractive risk adjusted returns outside of the financial sector. Investors should not be suckered into believing this sector is a bargain simply because it has declined substantially. That is the classic value trap if the fundamentals are bad as they are right now in financials. There's a sucker born every minute, but you don't have to be one of them.