The Prospect of A Fed Exit Creates Further Opportunity in Banking


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I hate to sound like a broken record (for younger readers, records were an early form of CD, and CDs were what we used for music back in the dark ages before downloads), but sometimes a thing bears repeating. I have said a few times over the last year or so that financials, and big banks in particular, still had some recovering to do and therefore represented value in a rising market. The sensitivity to news and the broader economic environment that banks have, however, creates two potential problems.

The first problem is obvious, that sensitivity means that with every one of the inevitable steps back, bank stocks will make an exaggerated move down. A look at the largest US financial sector ETF, XLF since I wrote this positive piece in November demonstrates that problem.

As you can see, it’s been a bumpy ride, but for those with the intestinal fortitude to stick with it, it has been worthwhile. XLF is up 7.33% since that article, not spectacular, but better than the S&P’s 6.0% in the same time. In that November piece I recommended four big US banks, Bank of America (BAC), JP Morgan (JPM), Goldman Sachs (GS) and Citi (C).

If you had initiated an equal weight investment in those four at that time, results would be even better (+8.66%). Despite the volatility, none of the stops suggested in that article would have been hit, making it relatively easy to ride the rollercoaster secure in the knowledge that you had an emergency exit plan in place. Bully for me, but does a correct call, albeit not a spectacular one, result in dangers of its own?

The second potential problem is that, as a writer and pundit, or as an analyst, one is as prone to the confirmation bias problem as anybody else, so potentially, yes. Once you have taken a stance on a stock or sector it is easy to read confirmation of your view into every price movement or piece of news. There is a fine line between conviction and bias. The financial sector has its share of perma-bears and perma-bulls. Since a remarkable and prescient call in 2007/8, Meredith Whitney spent years seeing every development as precipitating the next crash and Dick Bove has seemingly never found a time when financials weren’t just about to explode upward, for example.

I have been acutely aware of that as I consider the potential impact on the banks of Janet Yellen’s words last week. The Fed chair talked of increasing the pace of the exit from asset purchases (QE) and even, horror of horrors, made reference to the day in the future when the Fed will consider raising short term interest rates.

Even while searching my soul for signs of bias, however, I find it hard to see those developments as anything but positive for those big four banks. On the surface, the more rapid reduction of QE should be a bad thing, one would think. I mean, surely, as the Fed stops creating new money to hand to the banks every month, there must be a negative impact to said banks’ profitability, right? Well, not really.

That freshly made money is used to purchase assets that those banks had previously purchased. It must have been nice to go out and buy things knowing that there is a giant, ever present buyer lurking in the wings, but profit on those transactions would have been neither guaranteed nor particularly large. Put simply, however, the problem it created was that it delayed the day when financial institutions returned to the more risky area of lending to businesses.

Many have expressed surprise that, despite that regular inflow of new money and with ultra low rates, lending to business has remained relatively depressed. I, for one, am not surprised. To simplify the issue somewhat, banks are coming off of a credit crisis of historic proportions; if you offer them the opportunity to make money with a guaranteed backstop they will take it. As that backstop is removed they will be forced to go back to the more lucrative, and certainly more useful, business of funding business. If you couple that removal of training wheels with the prospect of a return to a normalized interest rate environment, then you have a recipe for success. Just as a return to the lending business becomes inevitable, so it becomes potentially more profitable.

Of course, for the modern breed of mega-banks, neither lending nor any other one business line has too enlarged an effect on the bottom line. Trading, asset management and a host of other factors have their say in the ultimate profit level of a big financial institution. In general, though, other business lines have been performing; it is the core business of lending that has been a drag.

With that likely to receive a boost as the Federal Reserve moves toward more normal market conditions it is hard to see that as anything but positive for the banking sector. The market seemingly felt that way as BAC, JPM, GS and C all gained on the day of Yellen’s press conference, even as the overall market declined. Logic would indicate that that was just the beginning and the rest of the year could see more outperformance by financials.

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

This article appears in: Investing , Investing Ideas , Economy , ETFs
Referenced Stocks: XLF , BAC , JPM , C , GS

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