On Wednesday, JP Morgan Chase (NYSE:JPM) CEO Jamie Dimon went before Congress to testify about his firm's recent large trading loss. Although the loss isn't huge relative to the firm's enormous balance sheet, we think the hedging gone wrong at America's premier bank underscores the larger issues with the industry. If Dimon, known as the nation's top risk manager, can't fully manage risks, then can any bank executive?
The entire banking sector has struggled since the financial crisis of 2008 and the subsequent government relief program. The sector underwent serious consolidation including Bank of America (NYSE:BAC) purchasing Merril Lynch, JP Morgan picking up Bear Stearns, and Wells Fargo (NYSE:WFC) acquiring Wachovia. Unfortunately for the sector, this caused some institutions to acquire some toxic assets that have weighed on profitability, like in the case of Bank of America's acquisition of Countrywide. Of course, this has happened against the backdrop of industry reform and broader economic uncertainty, challenging all of its players.
Due to the industry's uncertainty, Morgan Stanley (NYSE:MS), once one of the country's premier investment banks, now trades just above half of its tangible book value. Although Morgan Stanley has avoided much of the heat from the Facebook (NASDAQ:FB) IPO, the investment banking business remains slow. Even Goldman Sachs (NYSE:GS), an iconic brand in banking, trades at a significant discount to its tangible book value. However, the wealth management business, though challenged by independent financial advising, remains reasonably strong. Merrill Lynch and Smith Barney (though it will be renamed Morgan Stanley) are among the premier brands in the wealth management space. Wells Fargo has also started gaining traction in the space, as the economics of the wealth management business are much more attractive than the volatility of investment banking.
Though we think most of the larger banks, including Wells Fargo, Bank of America, JP Morgan, Morgan Stanley and Goldman Sachs are fairly cheap based on our fair value estimates (click here for our valuation reports which employ a residual income model), we would avoid any one concentrated position in the banking sector, as we instead prefer more diversified exposure. There is simply too much uncertainty with Dodd-Frank's implementation, the nebulous Volcker rule, and the enormous balance sheets of such large institutions (which, although proven to be sound based on recent stress tests, exhibit more risk than the typical operating firm). Investors may be able to realize fantastic returns in individual bank stocks during economic booms; however, we think the banking business will remain challenged over the near-to-mid-term from a number of fronts.
Given the tremendous downside risks associated with investing in any one bank, we prefer the Financial Select Sector SPDR ETF (NYSEARCA:XLF) and the SPDR Bank ETF (NYSEARCA:KBE) in the portfolio of our Best Ideas Newsletter. In these positions, we're able to participate in the upside potential of the space, while minimizing our risk to any one bank.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: Some of these securities may be included in our actively-managed portfolios.