FEAR versus FACTS: An incredible opportunity for the rational investor to make a long?term bet on stocks and financials stocks in particular.
"If you want to make money, real big money, do what nobody else is doing."- J. Paul Getty
Financials are currently the pariah of the investment community.
They are widely viewed as opaque, black?box businesses with unknown risks and challenged business models.
Emotion is the enemy of wisdom and the current fear is overwhelming the facts. We experienced a similar “bunker mentality” in 2008/09 but that was arguably warranted given that the financial system almost collapsed. I wrote a blog near the lows in June suggesting that the market broadly??and financials in particular??represented a great longer?term investment. While the recent crash has me underwater on that call, it has only increased the reward and reduced the risk of the opportunity.
First, stocks are cheap and financials are crazy cheap. As of Friday’s close, the Dow Jones was trading at 12X this year’s earnings and 10.4 X next year’s earnings (Bloomberg). The Dow has a dividend yield of 2.7% vs. the US 10-year yield of 2.25%. U.S. corporations have $2 trillion in cash to support these dividends going forward. The U.S. stock market has traded at a higher yield than the 10-year only a few times since the 1950’s and each time stocks have performed extremely well over the following 1, 3, 5 and 10-year periods. Over the last century, stocks have averaged a PE nearer to 15X. The only times historically when stocks have been cheaper, interest rates have been much higher. Financials in many cases are trading below run-off value indicating that either the ongoing franchises have no value or there are significant asset write-downs still to come. Given the regulatory scrutiny and asset seasoning, these seem unlikely.
Second, earnings quality is high. In the late ‘90’s, earnings multiples were not only much higher but those earnings were inflated by excess pension gains and hidden stock option compensation. A decade later, the earnings of financials appeared to be robust but were in fact inflated by overpriced assets and poorly documented “liar loans.” Those assets and pretenders are now cleansed from the system.
Looking through reserve releases on the financials, I see prodigious earnings power as measured by pre-provision, pre-tax operating earnings. On the asset side of the balance sheet, the really bad loans from 2005-2007 have seasoned and loans made since 2008 are performing extremely well.
Third, the fiscal situation, while challenging, is just not that bad. Current prognosticators (including, sadly, S&P) see only gloom and doom in the budget wrangling. But the seeds have been planted for positive change. The most important hurdle to overcome has been the lack of public awareness about the sustainability of current entitlements. We cannot keep allowing people to pay $1 into a system and receive $3 or $4 out. When current entitlements were created, we had vastly different demographics and life expectancy was much shorter. The solution broadly is obvious: some combination of increased retirement age plus means testing and a rationalization of healthcare spending must occur. The very positive benefit of the last month is that every American who reads the news is now aware of our problem and the fact that it must be addressed. I am concerned that Washington will seek to sustain current entitlements through massive tax increases, slowing economic growth when we need it most. That said, I do not believe the market vigilantes and business people of our now?global economy will allow much room for this unwise choice.
Face the fear: Invest selectively today in financials. Rational investors should be richly rewarded in the years ahead.
John Helmers has been active in the markets since the late 1970s. He has had stints trading or managing money for JP Morgan, Goldman Sachs, Tudor Investment Corp and Citadel. He currently is the principal of a private investment firm, Swiftwater Capital.