This commentary originally appeared on Real Money Pro on Oct. 18 at 8:22 a.m. EDT.
"We've been known from time to time to suffer from premature accumulation." -- Bruce Berkowitz, Fairholme FundWith last week's JPMorgan Chase ( JPM) third-quarter earnings release, yesterday's Wells Fargo ( WFC) profit miss and this morning's earnings reports for Bank of America ( BAC) and Goldman Sachs ( GS), it is now an appropriate time to review a financial stock sector strategy. Similar to Fairholme's Bruce Berkowitz, I suffered from "premature accumulation" in buying bank stocks and the Financial Select Sector SPDR ( XLF), when I grew more bullish on financial stocks several months ago. My current strategy for financial stocks, in summary:
- avoid bank stocks;
- short asset manager shares; and
- long life insurance companies.
Banks Are Trading Sardines, Not Eating SardinesI must admit, as Cumberland Advisor's David Kotok relates below, most of the headwinds facing bank stocks are now well known (and this would normally create a buying opportunity):
Nevertheless, while there will be intermittent trading ( sardine) opportunities in the sector, I see these factors as valuation/profit headwinds for years to come:
The financial stocks, which have been devastated for four years, are currently positioned for a buying opportunity. In Cumberland's case, we have scaled into financials several times and taken up the weights in the regional banks. So far, that is proving the correct course of action. We have taken the overall financials exposure above market weight. We continue to be a scaled buyer in financials. Ten days ago, the entire banking system of the United States was for sale below its stated book value. One could argue it was for sale below its tangible book value, which means you could buy all the banks in the United States at stock exchange prices trading for less than their liquidation value. Clearly, that is an absurd pricing level. Are banks now sound? Answer: some are, some are not. Are there still problems ahead in the financials and in the banking sector? Obviously, yes. Is regulatory change an issue? Again, yes. Are earnings derived from net interest margin an issue? Once again, yes. Does that mean that banks are dead forever? Our answer is a resounding no. The time to enter a sector and start to take up the weights is when it has been devastated in a bear market for several years and priced to an extreme. When you price the entire banking sector below its liquidation value, below its tangible book value, you are seeing a pricing level in a climate where all the bad news is known or identified. Only then are you are defining an entry point. Further, the financial sector has lost ten percentage points of the value share of the stock market since its peak. Think about this sector where it once was 24% of the market weight and derived 40% of the market's earnings. Now it is 14% of the market weight. Its earnings are substantially down from the peak earnings that were extant five years ago when everyone wanted to own financials.
- The big money center banks are suffering under the burden of cumbersome and expensive regulatory initiatives; they are the piñatas of populism.
- Higher ROE businesses (e.g., prop trading) are being reduced in size under the pressure of No. 1.
- The specter of low interest rates continues to pressure net interest margins -- and this won't change for many quarters according to Fed. Bank industry profit models benefit from higher interest rates, as banks have an imbalance of rate sensitive assets over rate sensitive liabilities.
- The capital markets outlook remains lackluster.
- Legacy issues continue to be costly (e.g., mortgages), as measured by both legal expenses and losses.
- Subpar worldwide economic growth and limited improvement in the employment rate suggest that the credit quality recovery of the past two years is maturing.
- Earnings power models for the bank sector have been revised lower almost every quarter and probably still remain too high. There is little low-hanging business fruit left in the way of pricing banking products (e.g., the imposition of a $5-a-month charge for checking won't dent the secular pressures).