Why Bank Stocks Are In For A Drop

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Includes: BAC, BTO, FAS, FAZ, FAZZ, FINU, FINZ, FNCF, FNCL, FXO, GS, IYF, IYG, JHMF, JPM, MS, RWW, RYF, SEF-OLD, UYG, VFH, XLF, XLFS
by: MF Capital
Summary

Inflation and interest rates aren't moving significantly in the near future.

The Financial Choice Act isn't displacing Dodd-Frank.

Bank stocks are severely over-priced for the time being.

Introduction

Banks stocks have been pretty hot recently. Goldman Sachs (NYSE:GS) is up nearly 43% over the past year and they're not alone. Morgan Stanley (NYSE:MS), Bank of America (NYSE:BAC) & JPMorgan (NYSE:JPM) are up 69%, 62% and 31% respectively over the past year. However nothing has truly changed over the past year. Inflation has remained steady, banks haven't been posting abnormal profits and Dodd-Frank has yet to be officially repealed.

On the other hand perhaps investors are right. After all rates are expected to rise in the very near future. As rates rise the low-yield rate banks offer on their CDs/deposits and the rate at which they lend that money to customers widens and they become more profitable. Actions by Republicans indicate that the death of Dodd-Frank could be coming any day now. Finally, Trump's proposed policies could catalyze some serious economic growth. But perhaps it doesn't matter whether any of these things come to fruition.

Addressing rates and inflation

If you've been at all paying attention to the fed over the past (almost) 8 years you would realize that the Fed has taken an extremely dovish approach to monetary policy since the 2008 recession. Rates are unlikely to move very quickly in the near future even with positive economic news.

For instance, unemployment has been on a steady decline since 2010 and for some time now has been considered at or near full employment (see below). Inflation has remained steadily at or above the Fed's target of 2% since November 2015 and spent lengths of time close to or above 2% between 2008 and 2015 (see below). Despite the strength of these economic indicators the Fed has remained stiff only budging the Fed Funds Rate from a target of 0-25bp to 75-100bp over a nearly 9 year period. Any slight deviance from ideal conditions (in the Fed's eyes) could deter them from raising rates again. We've already seen the inflation statistics for April 2017 below the Fed's target of 2.0% (reported at 1.9%). Hardly concerning but you can bet the Fed is keeping a close eye on those numbers.

Trending Economics

Bureau of Labor Statistics

Inflation could still begin increasing at a faster than anticipated rate however. Then, to keep prices in check, the Fed would be forced to raise rates. But the thing is inflation isn't going to go up, it probably isn't even going to stay at current levels. Unemployment is at an all-time low, the economy is running at max capacity. When unemployment is at its lowest point there's only one direction for it to go. Despite the tight job market wages have been stagnant for some time, if workers don't have more disposable income to spend prices can't increase.

Trump's economic growth-directed policies

I firmly believe that one of the biggest drivers of the increases we've seen in bank stocks recently is increased inflation expectations and economic optimism directly tied to Trump's proposed spending. Take for example his promise to spend $1T to repair America's failing bridges and roads. Following the release of Trump's budget proposal we see that he actually plans to slash Department of Transportation Spending by 13% (according to NY Times). Any optimism from proposed economy-friendly projects should be anticipated to be short-lived. His proposals for improving our economy have been far from static and at times have been borderline unrealistic. Expecting the economy to grow slowly from his proposed projects is risky to say the least.

Concerning Dodd-Frank

The House of Representatives today voted to advance the Financial Choice Act which many believe replaces the Dodd-Frank Act. It does not. In fact it doesn't even deregulate the financial sector. Even if it did either of those things it isn't anticipated to pass through the Senate, another huge hurdle for the bill. Republicans may bent on rolling back regulations of financial institutions but it will be a large feat on their part and even if it were to be accomplished it won't be happening any time soon.

Why none of this matters

Even if you disagree with my thesis that rates aren't going to rise by any discernible amount in the near future, that inflation will remain in check and that repealing Dodd-Frank will have a negligible positive impact on the banking sector there is a question that you should still be asking yourself. If these scenarios will act in favor of banking stocks, is it already priced in?

I absolutely believe so. I struggle to explain why banking stocks have increased as much as they have over the past year without citing investor expectations in the (possible) future events I have mentioned above. So if these securities are already priced correctly with the anticipation that all of the above events likely happening an investor in these stocks six, twelve, twenty-four months down the line isn't going to see any large returns from these events. They're already baked into the price of the stocks and one of two things will happen, either the aforementioned events will not occur and you will lose out big time. Or they will occur and you only secure marginal gains (if that).

In summary

Investors ought to be diligent and pragmatic in where they put their money. And if one were to take a closer look at how these stocks are priced currently they wouldn't dare risk their money. Bank stocks are currently over-valued, propped up on expectations of events that may or may not happen. Despite the uncertainty of these events they are already heavily priced into the stock. Do you really think that the overall intrinsic value of Morgan Stanley goes up 69% because rates rise, Dodd-Frank get repealed and Trump's policies cause economic expansion? Surely not. Avoid the banking sector the foreseeable future or risk losing a lot of what you put into it.

What should you do?

At this point in time I heavily recommend avoiding purchasing any stocks within the banking sector. That's not to say you should take on a short position on any stocks within the banking sector. I'm confident in saying that banking stocks are headed for a correction within the next 6 months but when exactly that will happen is still hard to say. Opening a short position exposes you to risk that the asset prices will continue to inflate in the very short term. Furthermore I would recommend hedging the majority of your portfolio that is made up of banking stocks using put options.

I would continue to follow this advice until we see banking sector asset prices deflate to a more reasonable level. I would define that level as returning to somewhere in the range of eliminating 40-50% of the gains these stocks have seen over that past year (excluding those banks that have experience significant events over the past year impacting the price to any non-negligible extent).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.