Avoid the Banking Sector

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Stock Market Video

Avoid the Banking Sector

Unexpected Events Occur Frequently

In Case You Missed It

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In this week's Stock Market Video, Cabot China & Emerging Markets Report Editor Paul Goodwin says that the past few weeks of downturn mean you should be holding lots of cash and curtailing any new buying. Stocks discussed: PriceSmart ( PSMT ), NetEase ( NTES ), Amazon.com ( AMZN ), Hain Celestial ( HAIN ) and SXC Health Solutions (SXCI) . Click below to watch the video!

Screenshot 5-18-12

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The May 10 trading loss of more than $2 billion by JPMorgan Chase & Company ( JPM ) has sparked a bevy of news reports. With good reason too-it's a massive loss from a bank that many have seen as a "safe haven" for the past few years. JPMorgan came out of the 2008 financial crisis with a surplus of money, and to now see something like this happen is making a lot of people wonder just how much bankers have really changed.

In doing some background reading on the trading loss, I found a fascinating explanation-on American Public Media's Marketplace website-of what exactly happened with the trader known as the London Whale and how that $2 billion (or more) could've been lost.  

To sum up, the trader was using derivatives to bet that certain investment-grade bonds would never, ever default. This was used as a "hedge" against losses, but back-fired in spectacular fashion because of a combination of factors. The first of those being the trader's supreme overconfidence in how smart he was, and the second being that rival traders bought up credit-default swaps that were then leveraged against him. The end result of this is that when the corporate bonds were marked down, the London Whale had painted himself into a corner and couldn't cover his losses.

And this is how JPMorgan, a company known for its apparently good risk management, showed that they really weren't that good at it after all. It has also added new scrutiny to the banking sector, which has already been battling increased regulation since the 2008 financial crisis. Predictably, JPMorgan CEO Jamie Dimon said this was a simple mistake and the company will learn from it and move on. He didn't say they'd never use derivatives as a hedge again … just that they'd learn from this mistake.

The loss resulted in an $18 billion drop in JPMorgan's market cap during the trading day on May 11, and earlier this week a quick search revealed four law firms filing securities class-action lawsuits against JPMorgan. The U.S. Department of Justice is also investigating the trading loss.

But all that is just background to my real argument today: It's not a good idea to invest in the banking sector right now.

This is true for several reasons, not least of which is that it's difficult at best to figure out how some of these banks make a profit. Back when I worked for Nasdaq, I routinely processed corporate earnings statements that public companies filed as part of their Securities and Exchange Commission disclosure requirements.

Banks had the most inscrutable earnings statements by far. At least with a pharmaceutical company, you could tell that their biggest expense was R&D and they made money when drugs were approved. With banks, I found it near impossible to tell where and how they made any sort of income.

This whole debacle with JPMorgan just underscores that same inscrutable nature of bank profits. If you can't figure out how a company makes its money, then you probably shouldn't invest in it. Mostly because if you don't know how profits are made, then you never know when that money is suddenly going to disappear.

The second, and perhaps more salient point for the current market, is that bank stocks are in a decline. Prior to the crash in 2008, bank stocks enjoyed a massive run due to deregulation and a host of other benefits given in the last years of the 1990s. Since that crash, however, investors have tended to stay away from large, multinational banks…with good reason.

JPMorgan lost $18 billion of its market cap overnight because of that trading loss. Investors who didn't sell once trading opened on May 11 could've lost a few thousand dollars depending on their position size. And this loss completely ignores the fact that other big banks, such as Bank of America (BAC) and CitiGroup (C) are in a persistent downtrend.

For investors interested in growth and seeing their stocks go up quickly, it's almost a no-brainer to leave banking stocks behind. Bank of America hasn't traded above 10 in more than a year, and CitiGroup has declined 36% in roughly the same timeframe. For a look at the broader market, the Financial Select Sector SPDR ETF (XLF) has been range-bound around 15 for the past two years (this is after it was at 37 at the height of the financial bubble).

I'll leave you with one final, redeeming comment for the banking sector. Not all banks are like the big names such as JPMorgan, Bank of America or CitiGroup. There are well-run banks at the regional or state level operated by good people who don't attempt the sorts of financial trickery of the big names. And to find those small, undervalued banks, I'd direct you to click here for some of Roy Ward's recommendations from Cabot Benjamin Graham Value Letter.

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Unexpected-Events2
Here's this week's Contrary Opinion Button. Remember, you can always view all of the buttons by clicking here.

Unexpected Events Occur Frequently

This is simply a reminder that we cannot know the future, and thus our investment decisions should be made knowing that the future will likely unfold differently than we anticipate. Sometimes it's better than we expect, sometimes worse, but being prepared for a range of events and outcomes can only improve our investment results.

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In case you didn't get a chance to read all the issues of Cabot Wealth Advisory this week and want to catch up on any investing and stock tips you might have missed, there are links below to each issue.

Cabot Wealth Advisory 5/14/12 -- My Favorite Stock

On Monday, Cabot Publisher Timothy Lutts suggested several ways you can avoid big losses but keep your portfolio's potential for growth. Tim also discussed why Tesla Motors (TSLA) is his favorite stock.


Cabot Wealth Advisory 5/17/12 -- Ten Tips for Traveling in China

On Thursday, Cabot China & Emerging Markets Report Editor Paul Goodwin wrapped up the travelogue about his two-week trip to China with some tips for the intrepid traveler. Paul also discussed the cushioning power of cash in a market correction. Featured stock: Latin American warehouse club PriceSmart ( PSMT ) .

Happy Investing,

Matt Delman
Editor, Cabot Wealth Advisory



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: AMZN , HAIN , JPM , NTES , PSMT

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