Financial stocks, like homebuilders, have become a favorite investment for contrarians. Drawn by the large dividend yields and low P/Es, investors have begun piling into the sector even as sovereign wealth funds — the guys who bailed out these stocks last fall — tell the banks to take a hike.
Financials have certainly experienced a temporary bottom as far as sentiment goes. Starting with their failure to establish a new low in mid-March, financial shares have rallied strongly as investors piled in and investment bank CEOs announced, “the worst is over!”
Much has been written about the market’s ability to discount the future. Personally I have never believed this myth. We have seen several major mis-pricings in the last three years alone.
The housing bust was obvious to anyone as early as 2005. But it wasn’t until the second quarter of 2006 that homebuilder stocks starting tanking. The same can be said of mortgage lenders. Everyone knew 2-year adjustable rate mortgages would begin resetting in 2006. Yet mortgage lending stocks plugged along just fine until the first batch of subprime lenders went belly-up in February 2006.
Simply put, the market does not always discount the future accurately. It certainly believed the worst was over for financial stocks back in August 2007—between August and October the sector rallied more than 10%. Investors who bought have since been taken to the cleaners.
What we’re witnessing today in financials stocks is not merely a matter of corrections and rallies. Instead, this is a multi-decade long bubble. From 1970 until 2003, financials’ market capitalizations as a percentage of the S&P 500 rose from less than 5% to 22%. Over the same period, financials’ earnings as a percentage of the S&P 500’s total earnings rose from less than 10% to 31%.
We’ve seen these kind of imbalances before. It happened with Energy stocks in the early ‘80s, when that sector’s market capitalization rose to 26% of the S&P 500. It happened again in the late ‘90s when Tech stocks’ market capitalizations rose to 32% of the S&P 500.
In both situations, when these bubbles burst there was a fundamental shift in market climate for these sectors. Things never again returned to the peak, though investors were seduced numerous times into believing they would.
Just as they are now.
Financials, for all their writedowns and plunging share prices, are still 17% of the S&P 500’s total market capitalization. The expected losses from the credit bubble have risen from $100 billion to $1 trillion in the last six months. Investments banks that were just as exposed to mortgage backed securities as Bear Stearns— most notably Lehman Brothers— have a long way to go downwards.
No one knows, including these firms’ managements, what is sitting on their balance sheets. When you’re leveraged by 33 to 1, with credit derivatives totaling trillions of dollars, raising a few billion here and there isn’t going to end your problems.
Financials have had a nice rally. But investors will sober up quickly when they realize the true fundamental shift that has occurred for these businesses. Dividends will be cut if not discontinued. Banks will go under. And financial stocks will plunge again to new lows, wiping out these gains.
