Financial Stocks: Where Will They Go Once Investors Sober Up?

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.

Comments

[User 124901]

So do you have a time table as to when the banks will go under?

[The Div Guy]

You must be getting killed on your short investments to write a fear mongering article. I am still buying financials! Best of luck.

[BlahBlah]

I have been buying financials all through this and would buy more if I were not loaded up. It's nice to see an article like this - so much of the fear has disappeared lately - I was starting to get worried.

If people aren't scared, I shouldn't be buying.

[texalope]

And you know this HOW? You provide no backup to your opinion. Why should I place any value on it. This article is a poor excuse for analysis. Hopefully this site will screen your writings before they let you publish again.

[John Egan]

Interesting point about the dividends being a driver for purchasing. Hadn't considered that..

Thx jegan ;-)

[Ryan]

Financials are in for some trouble. This is a case of "blood in the streets", yes, but not enough blood has been spilled. Expect a 20% haircut on current bank valuations before I'm willing to get in.

[Kentucky Fried Financial]

Yes, I think financials are cooked / fried !!!! Management of these firms have no credibility. John Thain of MER says they won’t need to raise more capital, then a week later the CFO of MER says he wishes Thain would not have made that comment, one week after that they raise $2.55 billion via a perp pref’d…..what a joke. Then last week Thain said their dividend was safe ….yeah right. I bet MER slashed their dividend within the next 90 days. The management of all the financial firms have to make positive comments about the soundness of their business because they have to convince investors to buy their secondary offering, bonds, etc… to shore-up their balance sheets. The financials are broken !!!! This crisis is FAR from over.

[Alpha Seeker]

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[Joe]

To some extent banks, etc. were functioning like casinos, to some
extent geared only to something like gambling. Out of touch with the
actual commercial / producing world.
Visitors to casinos are said to arrive with $ 100 and leave it with
$ 60, 40& thus lost. That is the average casino calculation, it could
be even higher.
If one takes a look at "assets under management" in banks balance
sheets one gets sometimes a rough idea how the casino worked,
at what percentage, so to speak. I would suggest to have a look
at UBS, to name just one example for an idea how their wealthy
clients were doing. And yes, in the long it is possible that people
are sobering up. In the long run, depending on the learning curve.

[ari5000]

I'm sure what you say is true - but the Fed is on their side and we don't know how long they can hide these assets -- maybe years. Maybe not.

Without full knowledge - people will buy and with government intervention -- they could put off a day of reckoning for a long time. Look how much debt the U.S. has racked up -- it seems it's only been in the last year where some consequences are actually being felt (via raging inflation).

I somehow doubt there will ever be a true day of reckoning. The Fed would probably prefer to kill the bottom 90% through hyperinflation than defend the dollar and allow the casino owners to face the music for their reckless lending.

[helplessobserver]

I think the author is more right than wrong. Just look at the TECH bubble. As a long term holder of Telcom I'm still waiting for VZ and T to hit $60 again. Likewise GE holders wonder if the stock will ever recover. Yes, a bubble means a long term correction and so will the financials.

[helplessobserver]

I think the author is more right than wrong. Just look at the TECH bubble. As a long term holder of Telcom I'm still waiting for VZ and T to hit $60 again. Likewise GE holders wonder if the stock will ever recover. Yes, a bubble means a long term correction and so will the financials.

[NoGuru]

A good article, I personally think any sector is a bad sector for equities when "sell in May and go away" is 3 days off. I think when the economy rebuilds after the commodity bubble bursts everybody will seek the financials. I am hopeful to get into them in early July.

[venividivici]

The fundamentals of these financial stocks are shocking. All of the smoke and mirrors games they played to inflate their earnings over the past five years or so are dead and buried. They are going to have to dream up a whole new set of games.

And the bad news keeps rolling in. Just today the German banks have announced more huge writedowns. But I dare say this will be greeted as more great news by the pumpers and permabulls. IT'S A BOTTOM,IT'S A BOTTOM!!!! BUY BUY BUY FOR GOD'S SAKE BUY.

[fxtrader07]

many "contrarians" who pile into the banks at this point will find out that they were not really so much contrarian and not contrarian enough anyway, after all. financials are rallying quite substantially - so either there are pretty many "contrarians" out there (besides some shorts who cover). Or it is not a contrarian play at all but just another rally to suck people into a false notion of a valuation bottom. The replies here reflect that pretty well. one or two agree with the author, while the rest is proudly waring their "contrarian" caps.
you know what? a bottom will not be announced by the CEOs of GS, LB and JPM all talking of "the worst has passed". It will rather come when they are scared to stick out their neck with such hollow forecasts, when they are slashing staff left and right and when people wonder how these companies will survive at all or whether they will ever make some real money again. Then will a contrarian's bottom be in sight.
And regarding "the market has discounted it all": Nobody knows what sits really on the balance sheets, not even the banks' ceos themselves, obviously. So how then can the market properly "discount" it? And after all, it ios a dynamic process. bank writedowns lead to cutailed credit which leads to a slowing economy, more unemployment and business failures and in turn more loan losses and defaults - voila, more writedowns.
I haven't come across anybody who could predict the magnitude of that - not the smartest bull not the most credible bear.

[Healthy]

The author is very late coming out with this hindsight article.

[Whisper On The Wind]

Looking back 15 years or so, when things crashed, I see where I got my inheritance. It was when my parents bought financials when they were way down, and they rode through the muddy parts, and the financials came back up, higher than before. Perhaps it was the particular stocks. Perhaps it was a glitch in the works. Maybe I just got lucky. But for now, I'll follow their example. You can all moan and groan, but since I don't need to spend the money now, the value is improving daily. I'm already ahead of the game and am starting to spread around a little. I'm tired of listening to everyone whine.

[fxtrader07]

@Whisper: the difference this time is: financial stocks come from a bubble of sorts and this one ain't coming back anytime soon. So of course most will survive and will return to profitability but valuations over the last 5-8 years have been way out of whack and bubble-valuations. unlike dot-coms they were not trading at sky-high p/es but on unsustainable and phony earnings. most of these earnings were just scams with costs arising in the future that eat away almost all of those profits if not turning into outright losses. a p/e of 10 is not cheap when the actual, true, real "e" actually is only a fourth or a fifth of the stated "e"