Bank stocks led the market lower once again on Monday after being largely responsible for the sell-off of the last month.
There appears to be two sets of reasons as to why the bank stocks are doing so poorly. First, if one uses traditional stock analysis one can argue that the stocks are reflecting expected weaker fundamentals. However, the second set of reasons is perhaps more compelling. Consensus analysis of this industry is deeply flawed at both the analytical and managerial levels and, therefore, it is creating instability in these stocks which is simply not necessary.
In traditional stock analysis one would look at the state of an industry’s raw materials, its manufacturing process, the quality of the products being produced, and the sales patterns of the business. In banking, this would not result in encouraging assessments.
In banking, the raw material is money in the form of bank capital and bank deposits. Bank capital is under severe pressure because managements are giving away literally hundreds of billions of dollars in stock buybacks and what remains is being eroded by higher interest rates. Deposits are under pressure because they cost more and the lowest cost deposits are leaving the banks.
The Federal Reserve is putting more stress on gathering raw material. It has dramatically slowed the growth in money supply by shrinking its balance sheet. If this were the oil industry, the fact that there was less oil available and it cost more would be a crisis. It is no less a crisis if the raw material is money, not oil, and the industry is banking, not energy.
The manufacturing process in banking is yielding very positive results. However, it costs a great deal of money. The breakthroughs in big data, robotics, and artificial intelligence are uniquely suited to the banking industry. Thus, the improvements in the manufacturing process is a major plus for the industry.
Product quality is slipping very slightly. Loan losses are still near all-time record lows but they are creeping up. The outlook for a potential slowing in economic growth is increasing and there are even suggestions of a recession looming in late 2019. A recession would result in a sharp deterioration in loan quality and a steep drop in bank earnings.
Product sales are sleepy. The key product that banks sell is loans and they are not selling at a rapid clip at the moment. There are competitive pricing problems within the industry among banks, and from outside the industry from non-banks. Other than the consumer, most major borrowers are requiring less funding. This is true in both the real estate, and commercial and industrial lending groups.
This is not rocket science. Bank stocks are doing poorly because banking company raw material sources are drying up and the cost of the raw material is rising. Plus, product sales are under stress and product quality may be weakening ever so slightly.
The approach to analyzing banks just described here is virtually never used. Instead a consensus approach to bank analysis has emerged that is theoretically bankrupt. It may be doing even more harm to these stocks than the underlying fundamentals suggest. The consensus view is that interest rates and the yield curve are the key drivers in bank earnings; stock buybacks and financial engineering, in general, is critical to bank stock performance; and governmental regulations and litigation determine how a bank should be run.
It would require a book length study to point out all of the absurdities in bank stock analysis so I will only point to a few here. Let’s start with interest rates. From 2010 to 2015, interest rates were at the lowest levels ever recorded. This led the pundits to argue for six years that banks could not make money when interest rates were “low for long.” However, in this period bank industry earnings hit all-time records 3 times and earnings were up in 5 of the six years. There were similar results from 1933 to 1945, the second lowest period of interest rates in the country.
It is also argued that banks cannot grow their earnings when the yield curve is inverted. The yield curve was inverted (Fed Funds rate above 10-Year Treasury rate) for most of the period from 1966 to 1970; 1973 and 1974; and 1978 to 1982. Bank earnings were up in every year from 1966 to 1970; they were up in 1973 and 1974; and they were up in every year from 1978 to 1982.
In fact, the period from 1966 to 1982 was possibly the worst on record in terms of constant reversion to inverted yield curves. In this whole period, bank earnings never went down. Facts like these mean nothing to the pundits; all they care about is their theories.
G. Bennet Stewart may be considered to have fathered the stock buyback movement when he published his book Quest for Value in 1991. Bank, managers, analysts, and the press strongly believe that banks should buy back large amounts of company stock. The problem here is that there is little or no evidence that it helps the stock prices (see comments about bank stock performance in the opening paragraphs above).
Yet, it is very clear that buying back stock reduces capital and the ability to leverage the bank’s balance sheet. This is harmful to the bank. It means that the bank has less raw material to manufacture and sell. Moreover, buying back stock lowers the secular growth rate of bank earnings and the present value of the institution.
The fact that bank Boards of Directors and bank managements believe that financial engineering is more important to long-term bank stock holders than building the company is doing great harm to bank stocks. The commitment to buying back stock is also an acknowledgement that the bank’s management does not know how to grow its business.
Government interference is one place where I agree with conventional wisdom to a limited degree. The government has de facto nationalized the banking industry by controlling its capital and the way that the industry lends its money.
However, from 2010 to 2017, or the period from the passage of Dodd Frank legislation to the present, bank earnings have been up in 6 of the 8 years and they are expected to rise in 2018, once again. Thus, even though governmental actions may be deeply upsetting they have not crippled the ability of the banking industry to make money.
Bank stocks are doing poorly because the fundamentals that determine their earnings are weakening. However, the stocks are doing worse than might have been expected because the consensus theory of bank stock investment is bankrupt. This is making committing funds to this sector quite risky.