While the release of 4Q earnings reports have capped an amazing run for the financial sector over the last year (the financial components of the S&P 500 rose over 24% in 2012, as the S&P 500 rose 13% overall), investors must question what happened to all of the risk factors that have kept banks trading below book value for so long. With JPMorgan (JPM), Goldman Sachs (GS), Citigroup (C) and Bank of America (BAC) all trading near 52-week highs, investors looking to buy low and sell high must consider the risks involved with trading financial stocks.
The United States has averaged 2.2% GDP growth during the past two quarters (2Q and 3Q of 2012, 4Q numbers have yet to be announced), with unemployment stuck at 7.8% as of January 2013, only .7% lower then this time last year and unchanged from November 2012. These numbers do not inspire much confidence, which is why the recent run in financials is surprising to some as their performance is closely tied to that of the US economy. The stagnation our economy is experiencing leaves us especially vulnerable to shocks that would not be much of a threat were we seeing a period of robust growth.
The position that our economy is in now is a precarious one. If our political dysfunction is resolved and we are able to avoid any of the risk factors listed below, growth will speed up and unemployment will start falling. However, one unexpected "'black swan" event (an event with a very small probability of occurring but a massive effect on the economy, such as the Flash Crash in 2010) could push us into another recession, which would be bad news for financial companies.
Below are what I see as the biggest risk factors for these financial companies, in no particular order.
Regulation: Lobbyists for the financial sector have done a good job at preventing meaningful regulation of the banking industry, but there is always a risk of additional regulations coming down. The LIBOR scandal did not inspire much public outrage (possibly due to the complicated nature of it), even though it could've provided a rallying point for those calling for tougher regulations.
Obama winning the presidential election means more of a risk of increased regulations for the banks, as opposed to Romney who was planning on repealing Dodd-Frank. While that would seem like a good thing for financials, the "living-will" component of the act helps ensure that banks remain "too big to fail." Although the banks can feel confident that they won't be forced to downsize any time soon, President Obama does not have another election to worry about so he may become more aggressive in pushing for regulations
Inflation: While the low interest rates and monetary stimulus enacted by central banks across the world have not been inflationary as of now, as "easy money" continues, it becomes more and more likely that inflation rears its ugly head. While gold (used by many investors as a hedge against inflation) hasn't touched $1,800 in over a year, recent actions by central banks could change that.
Ben Bernanke announced in December that the Federal Reserve would be tying monetary easing to unemployment and inflation. While the markets rose in reaction to this news, there are risks involved with this approach. If unemployment approaches the 6.5% mark that Bernanke set, corporations may start spending the cash that they have been sitting on for the last few years. A rapid influx of money could be inflationary as the economy "overheats" and the Fed tries to unwind its balance sheet.
The Bank of Japan also announced that they would be doubling their inflation target to 2%, a sign that other central banks want to remain competitive with the dollar. Such moves could trigger similar actions from other banks, which could mean a "race to the bottom" as every country tries to keep its currency competitive.
Fighting over deficit reduction: While Congress was able to avoid falling off of the fiscal cliff, the day of reckoning may be coming soon. The "No Budget, No Pay" Act, which was passed by the House, would freeze the pay of Senators and Representatives until a federal budget gets passed. This raises the stakes for Congress, and makes it more likely that there will be more fighting over what should be done to close the deficit. As has been seen in Europe, austerity will hurt growth and raise unemployment. While our national debt has to be taken seriously, it has to be recognized that a large reduction in government spending and tax increases will hurt our economy and make it more difficult for banks to stay profitable.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.