Valuentum covers recent developments in the financials sector, including hopes for a relaxation of certain prohibitive Dodd-Frank rules that, if repealed, could pave the way for improved economic returns across the banking sector during the Trump administration. A look back at the month of September 2008, and how Goldman Sachs may very well shape the financial markets during the next few years are two other areas in the piece. Financials stocks have come roaring back since Trump was elected the 45th President of the United States. We’ve participated.
By Brian Nelson, CFA
It’s been more than 8 years now.
The month of September 2008 shaped my view of the financials and banking sector more than any other month possibly could–The Wall Street Journal pages etched in my mind, the crisis ‘specials’ on CNBC, the late-night coverage on Bloomberg, the ongoing heated debates at the office. “Crisis on Wall Street as Lehman Totters, Merrill Is Sold, AIG Seeks to Raise Cash” graced the cover of the Wall Street Journal September 15, 2008. “WaMu Seized, Sold Off to J.P. Morgan in Largest Failure in U.S. Banking History,” would be the headline a little more than a week later.
These weren’t headlines during the largely unregulated banking environment of the early 1930s following the Crash of 1929. No – these were headlines in the 21st century on companies we all know very well by name. Perhaps we even worked for them, too. There were many causes for the Financial Crisis of the last decade (the repeal of Glass-Steagall, loose lending standards, liar loans, too-much leverage, too-optimistic credit ratings, derivatives, to name a few), and there has been a lot of finger-pointing since, but that the Financial Crisis happened is enough for me to always cast a cautious eye on the financials and the banks in general.
Every bank is different, some with fantastic missions and unique competitive advantage, but they all are the same in one very important way: they generally operate highly-leveraged business models that don’t hold enough capital on hand to repay depositors in full. It is simply the nature of their business, and as a result, they will always be exposed to “run-on-the-bank” risks. No, perhaps not a run-on-the-bank like that of the Bailey Building and Loan in It’s A Wonderful Life. But one like that of WaMu in 2008, or one of the digital variety, can never truly be ruled out.
During the Obama administration, the Federal Reserve has annually assessed whether the largest bank holding companies have sufficient capital levels to handle adversity (and challenges to confidence) that may cause an all-out failure of their institutions. Dodd-Frank legislation, in our view, has largely been responsible for the banking sector’s inability during the past several years to generate a collective return on equity (ROE) above its cost of equity (COE). Holding too much equity to protect against adverse conditions depresses the percentage returns generated on the outsize capital in place. Since 2009, the largest 33 bank holding companies have added $700 billion in new common equity capital, according to the Federal Reserve.
That said, the lower returns due in part to higher capital bases generally means that banks are operating on much firmer foundations, but the higher costs of regulatory compliance have also weighed on profits, driving General Electric (GE), for example, to take actions to even shed its SIFI (systematically important financial institution) designation. The latest reading of the Federal Reserve stress tests, the ones released June 2016, however, showed that “the nation’s largest bank holding companies continue to build their capital levels and improve their credit quality, strengthening their ability to lend to households and businesses during a severe recession…[Capital is important to banking organizations, the financial system, and the economy because it acts as a cushion to absorb losses and helps to ensure that losses are borne by shareholders.]” From our perspective, during the past several years, bank returns have been sacrificed to ensure ongoing global financial safety.
The election of Donald Trump as the 45th President of the United States has put into question at least some of the Dodd-Frank regulations that were implemented following the Financial Crisis, including even the nature of the supervisory stress tests. The soon-to-be-President has argued that Dodd-Frank rules have only made the big banks bigger (e.g. the too-big-to-fail mantra) while causing local community banks to close their doors, leaving the tax payer on the hook and costing jobs. The extent of any dismantling of the Dodd-Frank Act under the Trump administration (including the ‘Volker rule,’ which bars financial institutions from making certain speculative investments) will certainly be politically-charged, but if capital requirements are loosened (and well-capitalized banks are allowed to pursue more speculative endeavors), the group may once again be in a position to consistently generate economic value for shareholders. Bank stocks, including and especially the largest investment banks and money centers, have been rallying hard as a result.
Bank of America’s (BAC) stock price has advanced more than 35% since Election Day, Goldman Sachs’ (GS) 34%, Morgan Stanley’s (MS) 28%, J.P. Morgan’s (JPM) 24%, Wells Fargo’s (WFC) 21%, and Citigroup’s (C) 19%. Though the yield curve plays a very important role in the profitability of lending institutions, the market price leadership by the investment-banking money centers implies that optimism is running rampant on the roll back of the most prohibitive Dodd-Frank regulations. Adding more fuel to the fire, Trump has been hiring Goldman Sachs’ executives to his cabinet around every turn. The President-elect’s choice for Treasury Secretary, former Goldman banker Steven Mnuchin, has vowed to “strip back” Dodd-Frank rules, and candidly, he would know which rules to relax to drive the sector to new heights. Other Goldman veterans added to the Trump team include Steve Bannon, new chief White House strategist, Gary Cohn, new director of the National Economic Council, Jay Clayton, new head of the Securities & Exchange Commission, and most recently Dina Powell, new senior counselor for economic initiatives.
We’re optimistic of what changes the Trump administration may bring in the coming years, even as we note the severe risks of the regulatory pendulum swinging too far back in the other direction (as arguably what happened with Glass-Steagall in 1999 prior to the dot-com crash), but I’ll never forget September 2008, and I doubt Trump’s new advisors will either. After all, they, like me, lived it, breathed it, and studied it. They know the weaknesses of the banking business model and the global financial system, as well as the importance of confidence as the duct tape that holds everything together. They simply know that Goldman Sachs, itself, in that same month of September 2008, received its very own private “bailout” from Warren Buffett’s Berkshire Hathaway (BRK.A, BRK.B). That’s right—on September 24, 2008, Warren Buffett said he would invest up to $10 billion in Goldman to steady the waters at the time, a 10%-20% stake in the global investment bank. We believe any roll back in banking regulations will be pursued with caution, and we think Trump’s Goldman cabinet will get things right. The stakes are too high.
We highlighted a very fascinating small cap bank in the January edition of the Nelson Exclusive, released January 7, and the Best Ideas Newsletter portfolio has been reaping the rewards of a conservative and diversified stance on banking equities. The newsletter portfolio includes both the Financial Select Sector SPDR (XLF) and the SPDR S&P Bank ETF (KBE). Please note how we can be cautious about a company or group in our writing, but still have exposure to it. Every security holds some degree of risk, and only through assessing such risks in full can we effectively determine our preferred exposures. Largely under the radar, these two investment vehicles, the XLF and KBE, have roughly doubled since they were added to the Best Ideas Newsletter portfolio, and the Financial Select Sector SPDR, in particular, includes arguably the prime beneficiaries of potential regulatory relaxes in 5 out of its top 6 holdings—J.P. Morgan, Wells Fargo, Bank of America, Citigroup, and Goldman Sachs. Berkshire Hathaway, a holding in the Best Ideas Newsletter itself, is also a top holding in the Financial Select Sector SPDR, and we can’t complain. The stock price of Warren Buffett’s Berkshire has advanced nearly 10% since Trump was elected.
We outlined our “5 Shocking Stock Market Predictions for 2017” in late December, including expectations for the ongoing stock market bubble to continue to inflate, with both crude oil prices and the 10-year Treasury continuing their respective advances during the year. When it comes to the banks, rising Treasury yields offer significantly more opportunities for net interest income generation and net interest margin expansion, but we’ll be watching movements at both the short end and long end of the yield curve to assess ongoing bank health as well as their technicals to evaluate market confidence in the global financial system as a whole. Though we expect consumer staples stocks to underperform during the year in light of their respective relative overvaluations, we continue to expect Donald Trump to be the “wizard behind the curtain” to drive the market to new heights in 2017, even as we note the very real risks of a fall-out in the market during the latter stages of his Presidency (if on the basis of valuations alone). The market is at frothy valuations (the S&P 500 is trading at more than 17 times forward earnings at the time of this writing), but that doesn’t mean it can’t keep going higher during 2017 before reversion-to-the-mean dynamics begin to take hold, if they take hold.
Some of you may have decided to retain the special stock dividend of the Financial Select Sector SDPR (XLF) in the form of The Real Estate Select Sector SPDR Fund (XLRE), which was paid in September, as State Street modified the index constituents of the Financial Select Sector Index, shedding it of real estate exposure (as real estate became a new sector in the S&P 500). The distribution for the special dividend from the XLF in September was 0.139146 shares of XLRE or $4.44356 per share of XLF (or ~18.7%). In the case of the Best Ideas Newsletter portfolio, the special stock dividend was converted to approximately 28 additional shares of the XLF, an equivalent increase of ~18.7%, at the time. While rising rates may pose opportunities for banking entities, since many real estate considerations are influenced by cap-rate assessments, rising rates offer material headwinds to real estate valuations, even if many REITs may offset such hurdles through net operating income expansion.
Overall, we really can’t complain about all-time highs in the Best Ideas Newsletter portfolio again! Our 2016 additions to the Best Ideas Newsletter portfolio have been performing quite nicely, too. We added six new ideas to the Best Ideas Newsletter portfolio during 2016. Facebook (FB) and Johnson & Johnson (JNJ) were added in January 2016. Kinder Morgan (KMI) was added in February 2016. Berkshire Hathaway (BRK.B) and the SPDR S&P Dividend ETF (SDY) were added in April 2016. General Motors (GM) was added August 2016, and all have advanced nicely since making the cut. We recently added CVS Health (CVS), and please have a read of our write up in this edition if you haven’t read the piece on the website yet. Though other newsletters and research firms may trade a position dozens of times over the course of several weeks, you know that stock selection takes patience, and swinging at a fat pitch is much better than swinging at every pitch.
With each new year, I always like to remind members that you can always reach out to me if you have any questions, comments, or concerns. We always put our customers first, and we sent a reminder on how you can cancel your membership if you’d like. I hope you won’t, but we’re here for you and we put your interests first. Also, it’s always a good time to remind you that Valuentum is a financial publisher, not a financial advisor, and that you should always be sure to check with your personal financial advisor that knows your individual needs and risk tolerances to ascertain whether any idea is ever right for you. With that said, I’m energized and excited as ever by what 2017 may bring. Let’s make it the best year yet!
Tickerized for holdings in the exchange traded funds, XLF and KBE, and for various financials-oriented ETFs.