The investing community remains split over how the financial sector will perform over the next couple of years. Having gone through one of the greatest booms, and subsequently one of the greatest busts of all time, investors are struggling to pin down the 5 year outlook on the industry. We believe that financials will underperform the indices over the next couple of years, despite having played a lead role in the violent rally that has taken place since March.
The collapse of the tech bubble gives us a blueprint for analyzing the future of financials. After leading the market upwards in the late 1990s, tech underperformed over the subsequent bull market of 2003-2007.
Additionally, while financials have been a high beta sector over the previous months, we believe that they will lose beta over the next year and their volatility will be increased on pullbacks rather than on rallies. This reduction in beta also occurred with tech post-2002. The sector reached a beta of over 2 by 2002 but currently trades with a beta close to 1 (the XLK currently trades at 1.06).
The current bullish arguments revolve around the idea that the collapse of Lehman (OTC:LEHMQ) has opened a gulf for other banks to expand into, thus providing growth expectations. In addition, the robust profits seen at banks such as JPM and GS in 2009 are largely the result of trading profits which won't be replicable, especially as credit spreads fall to normal levels. There simply is no reliable way to quantify the benefits of having a consolidated field of competition for the entire industry. We believe that most of the expectations around this shift have already been baked into the stock prices over the current rally.
To the contrary, there are a host of looming problems for financials as we enter the next decade. First, with stubbornly high unemployment and continued over-hang in the commercial real estate sector the banks must still fear write-downs. This is especially true for the CMBS markets as well as the Alt-A and Option ARM markets as rates reset over the next few years. Meredith Whitney has repeatedly stated that she believes capital levels remain inadequate at many major banks.
Second, the looming threat of regulation on a host of levels will ensure that uncertainty surrounds financial profits and even business models over the next 5 years. The salience of politically risky bonuses will make it harder to attract top talent to the industry, as will the decline in bankers' reputations. Regulation of the futures and commodities markets' will also be a big factor. None of this is even to mention the massive impact that the potential reinstitution of Glass-Steagall would have.
Rising interest rates and inflation will also serve as headwinds for the banking industry. Whereas the previous decade was one of subdued inflation and low rates, the next few years will be the exact opposite environment. The dual waves of securitization and consolidation that drove the previous bull market cycle will both be gone. Finally, while the rest of the market will benefit from the growth in emerging markets, banks will only be secondary beneficiaries as most EMs have either regulated financial sectors or entrenched homegrown banks. India has HDFC (HDB) and ICICI (IBN), Brazil has Itau Unibanco (ITUB), Banco Bradesco (BBD), and Banco do Brasil. China's tightly regulated financial industry will offer little opportunity for American banks and financial institutions.
All of these problems are juxtaposed against the absurd expectations seemingly placed on financials over the course of 2009. Does anyone really expect Goldman Sachs to continue performing like they have? Jokes about deities aside, we'd advise you to underweight financials.
Disclosure: Author holds no positions in the ETFs or stocks mentioned.