The markets are a moving target and nobody knows which direction the target will head. I have listened to all of the pundits, all of the talking heads, and all of the experts about how the market will continue to go up, or is ready to crash. It might even trade sideways for awhile.
The simple lessons I have learned in my investing life still ring true today:
The trend is your friend.
Never fight the Fed.
I have seen plenty of up trends and some nasty downward spirals that make investors flee, but I have never seen an accommodative Federal Reserve take as much risk out of the financial sector as I have with good old Ben Bernanke, et al.
I believe that given the current scenario that investors face, the financial sector could literally explode this year to the upside. My personal favorites are Bank of America (BAC), Citigroup (C), JPMorgan Chase (JPM) and Wells Fargo (WFC).
Let's Review The Key Factors
Looking at the simple stuff first, each of the stock's share prices have recovered from the 2009 lows, and with some fits and starts, have ALMOST traded sideways.
In the past year, each has shown some nice gains, but none of them are anywhere near their pre-crisis highs. I am not suggesting that they will get there anytime soon, but the table is set for each of these banks to continue their upward trend.
The simple reason is that the Fed has made it easy for them to make money. Each bank can borrow at the lowest possible rates of nearly zero interest, and lend wisely at low rates with much less risk.
As a matter of fact, each of these banks has been able to make money just in fees and services. The mortgage lending business has not been very lucrative simply by the fact that the banks have so many issues from previous lending practices, that they have shied away for this business segment... until now.
Now that the 10 year spread is about 200 basis points from the base, and the 30 fixed mortgage rate is finally over 3.53% again, the banks can make money by taking mortgage loans again.
Not only that, but they have all tightened up their lending standards to reduce their own risk, and now even have a "consumer" agency that is setting the lending standards for new mortgages.
The CFPB has defined the standards in the report noted, and not only does it help the consumers realize they can only afford what they can really afford, but this agency has also mitigated much of the litigation risks that each of these banks faced.
The key points of the new standards are quite simple:
The debt-to-income ratio cannot exceed 43% to qualify for an FHA mortgage.
Qualified mortgages would not have interest-only features, nor balloon payment "trip-ups."
There would be a 3.5% cap on loan origination fees.
Banks that conform to these standards will be shielded from future litigation.
Now, in addition to the fee and service structure that has led each of these banks to profitability, the mortgage business could become extraordinarily profitable once again.
If the banks follow the rules they will have almost no litigation exposure. That alone gives the banks more breathing room than they have had since 2007, when it comes to mortgage lending.
The Fed Is The Financial Sectors Best Friend
It is far from unknown what the policy of the Fed has been for the last 4 years, but it does bear a brief review.
A zero short-term interest rate policy (ZIRP), that allows banks to borrow at near zero interest rates. This in turn allows the banks to lend, even with rates at the longer end of the curve remaining low, and make money.
The Fed continues to buy $85 billion in longer-term Treasuries and mortgage backed securities, monthly. This keeps rates lower than they would ordinarily be, which has the effect of offering very attractive loan rates to both individuals and corporations.
By keeping the "lid" on interest rates, the housing sector has been able to gain some traction, which of course inevitably leads to more mortgages being written by these banks, no matter what the standards are.
The Fed has repeatedly stated that this policy will be in place until the unemployment rate drops below 6.5% and the inflation rate goes above 2.5%:
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4% and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2%, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2% longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2%.
The Natural Progression
It does not take a rocket scientist to realize that as this environment stays in place, the stock market should go higher. Much higher. Obviously that is my opinion, but let me spell out my "blue-sky" reasoning.
If money is cheap and loans are made, businesses can grow.
If loans are made by banks, then the banks will make more income with greater revenues than they have in the last few years.
If the banks make more money, they will lend more to both individuals, for mortgages, home improvements, cars, etc. As well as to corporations to enable them to expand.
If mortgages are given, the housing sector can continue to recover and grow. If auto loans are made then more cars will be sold, and if more home improvement loans are made, then consumer spending will rise in the retail sector.
As loans are made to corporations, they could expand and hire. If they hire, then the unemployment rate can drop.
As the unemployment rate drops, more revenues will come back to the Treasury which can then become fiscally responsible and pay down the national debt.
I realize I am painting quite a rosy picture here, but is it so far fetched to look at the glass as half full? After all, we have plenty of folks already looking at the glass as half empty, and about to be completely dry.
What all of this boils down to is that the financial sector, which I have defined as the big banks, will lead the way in 2013 and beyond. I believe that with all of the policies currently in place, as I have outlined above, a basket of bank stocks can be developed with shares of BAC, C, JPM, and WFC.
I believe that any or all of the bank stocks I have noted have significant upside potential just by the fact that they can make more money lending now, with far less risk. Since each of them has right-sized themselves, they are already making money hand over fist without lending. Now the landscape is in their favor once again.
If the landscape is in their favor, we might be able to profit handsomely as investors.
Disclaimer: This article is my opinion and not a recommendation to buy or sell any security. Please do your own research prior to making any investment decision, and do not rely on anyone's opinion without your own due diligence.