Why the Gravy-Train is Over for Most Banks in the Years Ahead
Today's comment is by Eric Roseman, Investment Director and editor of Commodity Trend Alert for The Sovereign Society.
Dear A-Letter Reader,
From 1982 until the first half of 2007, global bank stocks led the secular long-term bull market in company profits. Long-term interest rates plunged from over 21% in 1981 to a low of just 3.5% in 2004. As a result, earnings at the majority of banks were literally stupendous, including huge dividend increases and massive shareholder buybacks.
But that party is over. And in all probability, bank stocks will remain poor investments over the next five years and beyond.
In the next few years, I see a host of formidable challenges facing the badly bruised financial services industry. This includes new government regulation, losing the traditional investment banking deal-flow and far less lucrative leveraged loan portfolios. All these factors are conspiring to make financial services stocks a dull investment proposition.
The Financial Sector - Flying High Until Last July
The Easy Money is History
Most banks have been operating as casinos for years...that is until last July. Suddenly the sub-prime crisis imploded credit markets.
Sub-prime's collateral damage will revolutionize the way banks do business going forward. In all likelihood, some of the most profitable revenue streams on Wall Street will disappear, mostly those tied to CDOs or collateralized debt obligations and other illiquid and hard-to-price synthetic securities. Worse, government regulators are bound to reshape the way investment banks mark these illiquid securities. In some cases, I can see banks even forbidding to trade the more exotic and leveraged securities that risk trashing the financial system.
In a nutshell, the investment banking business model is about to change. For shareholders, this implies far less profits as traditional sources of revenues are streamlined or liquidated altogether in 2008 and beyond.
The Fed, Bear Stearns and Systemic Failure
In order to avert a probable run on U.S. and many international prime brokers in March, the Federal Reserve orchestrated a US$39 billion dollar bailout for Bear Stearns. This event marked what many pundits called the "end of the sub-prime crisis" because the Bernanke Fed unofficially guaranteed all major U.S. financial institutions would remain solvent.
The implications of this watershed event are enormous. The Bear Stearns saga shows with brutal clarity that modern financial markets are even more tightly interwoven than before. That leaves regulated institutions even more exposed to each other's risks. The next U.S. administration will spearhead a global effort to legislate and superimpose a watchdog on the financial services industry as the threat of systemic collapse is addressed through policy initiatives. More rules or restrictions won't be bullish for bank and investing banking revenues.
The bottom line for the banks and their shareholders is not inspiring.
Greater financial market regulation, especially as it pertains to credit risk, will reduce long-term earnings for most investment banks worldwide. Even with Wall Street's uncanny ability to create new models to maximize profits, government regulation and a new set of restrictions will likely dilute the innovative financial product development.
Increasingly, the government will scrutinize dealers and market-makers to isolate where systemic risks threaten the global financial system. And I can see the government destructively harsh on Wall Street.
Buffett Correctly Predicts Shareholder Dilution
In an interview with the National Post in Toronto, Canada, earlier this year, Warren Buffett of Berkshire Hathaway urged his audience to avoid most bank stocks in the future. Buffett stated that although some banks might be fair long-term investments, other sectors of the market offer far superior returns.
Buffett correctly predicted a wave of rights offerings. In other words, banks diluted their own banking shares by issuing a rash of new, public shares to finance bulging losses. Five months after his speech in Toronto, Buffett's prediction came true. Today, many U.S. and European banks have already announced new rights offerings this year to shore-up depleted capital ratios.
For the record, Buffett does own stakes in U.S. Bancorp (NYSE-USB) and Wells Fargo (NYSE-WFC). The former is probably the cleanest of all U.S. large-cap banks with no sub-prime exposure.
U.S. banks have already issued more than US$26 billion worth of preferred stock in 2008 to bolster their balance-sheets. Merrill Lynch this week announced a US$4 billion offering while Citigroup has issued billions in preferred securities since late 2007.
To date, global banks have lost over US$200 billion dollars with Switzerland's Union Bank of Switzerland (NYSE-UBS) responsible for almost 20% of that total. The International Monetary Fund or IMF has pegged total losses tied to sub-prime and other credit losses to peak at roughly US$1 trillion. That suggests banks still have a stash of cash to write-down over the next several years.
Dead-Cat Bounce or Market Bottom?
From their lows in mid-March following the near-demise of Bear Stearns, U.S. bank stocks have gained 14%. Now investors are starting to bargain hunt amid the credit wreckage.
To be sure, some banks are probably worthy investments at these levels assuming write-downs have peaked and their respective dividends won't be reduced or cut entirely. But for most of the financial sector, more pain lies ahead as other segments of the credit markets and real estate come undone.
The United States is likely to suffer a prolonged economic slump as sub-prime and other facets of credit continue to unwind, constricting bank lending and reducing the economy's ability to recover quickly like it did in the 2001 recession. Also, the next administration will spearhead a global effort to regulate financial services - especially segments of investment banking that threaten the financial system. That won't be bullish for earnings.
Some banks probably belong in a diversified global portfolio. These should include institutions with no sub-prime loans, minimal securitization revenues tied to real estate and capital Tier 1 Ratios at or above international standards. And yes, make sure the bank pays a dividend, too!
ERIC ROSEMAN, Investment Director
EDITOR'S NOTE: With this disappointing financial sector, Eric is sticking with strong long-term commodity plays in the food and beverage sector, mining and precious metals. And this past month's minor commodity pullback has created some major opportunities for Eric's Commodity Trend Alert subscribers. Just last week, he recommended one of the world's favorite candy companies, and two more plays that take advantage of this farmer's bull market. (Commodity plays like these have helped Eric grow his portfolio of 40 plays - with a stunning average of 119% - including both winners and losers.) Click here to learn more about Eric's service now.
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Reversal of Fortune:
Markets Go from Worst to First in Under a Month
It's hard to believe that summer's heat (and hurricane season) is almost here. As the calendar turns to another month it's often quite interesting to take a look back at the past month to see which trends may be in for a switch.
One phrase comes to mind that perfectly sums up April's market action: A reversal of fortune! From November through March U.S. stocks (and most global equity markets) suffered a string of five-straight monthly declines. That's a very rare occurrence that has only happened on a handful of occasions in the past 40 years.
Sure enough, April saw a sharp reversal of the five-month downtrend. The Dow Jones Industrial Average had fallen over 11% at the March low. But the Dow got up off the mat in April and rose 4.5%. The Dow wasn't alone. In fact, international stock markets pulled off much more dramatic reversals.
Japan is perhaps the most striking turnaround. I've been bullish on Japan since last year... and had been proven way too early through March. But Japan rallied strongly last month - soaring 11% in April alone - it's biggest single-month gain since 1995! In spite of this rally, Japan remains one of the world's most undervalued major markets, but now it looks like global investors are catching on.
Hong Kong, another one of my favorite overseas markets, also pulled off a major turnaround in April. After dropping -18% in the first quarter of 2008, the Hang Seng Index jumped 13% last month.
Taiwan, another favorite, rose 4% in April. Mainland China bounced back too - 6.3% last month. But Shanghai shares still have lots of "heavy lifting" ahead -they're still down 30% year to date.
Perhaps the biggest surprise was commodities. Gold and crude oil rallied pretty much in tandem through the end of 2007 and early 2008. Oil was up another 12% in April - adding to gains of nearly 20% year to date.
The yellow metal however declined nearly 6% last month. That's gold's second consecutive monthly decline - perhaps this precious metal will go for five in a row too!
Of course last month's market action could prove very fleeting indeed. And I doubt that the ultimate "bottom" of this bear market has yet been reached. However, with such broad-based strength in equity markets around the world, we may be in for a decent rally that has some legs.
On Wednesday, the Fed cut rates again as I expected to 2%. The financial media seems convinced that the Fed intends to "pause" sometime soon. That has helped the beleaguered U.S. dollar (talk about a bear market!) to stabilize somewhat.
If the buck can stage a more convincing reversal of fortune at this point, I would expect commodities to correct further, while global stocks (particularly emerging markets) should continue to get a boost. Stay tuned...MIKE BURNICK, Senior Editor & Global Markets Analyst
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You Give a Local Government an Inch...
I've written about some wacky anti-terrorist initiatives in the good ole' USA over the last eight years, but most of them don't hold a candle to those in the United Kingdom.
Case in point: The U.K.'s Regulation of Investigatory Powers Act (RIPA). When the U.K. Parliament enacted this law in 2000, proponents claimed it was urgently required to deal with "new technologies" allegedly used by terrorists and the like.
Among other provisions, this law:
- Allows the U.K. government to issue a secret demand for your email and browsing records from your Internet Service Providers
- Facilitates mass surveillance of cellular phone calls
- Forces telecom companies to install equipment to facilitate mass surveillance
- Requires targeted individuals to hand over their encryption keys and passphrases
However, one of the lesser-known effects of the RIPA enables local "Councils"- the U.K. equivalent of city governments in the United States - to conduct their own investigations using these same provisions.
The only limitation is that councils may not wiretap phones - this power is reserved for police and intelligence services. Indeed, according to figures recently released by the U.K. Office of the Surveillance Commissioner, local councils initiate approximately 1,000 covert surveillance investigations each month.
Naturally, this authority is being used only to investigate extremely serious crimes. Some of the "terrorist-related" offenses currently under investigation include:
- Children under the age of 18 using tobacco
- Council residents failing to properly segregate their trash for recycling
- Parents lying on a child's application form to gain admission into an elite school
- Illegal dumping
This wholesale abuse of these surveillance laws should surprise no one. I've long observed governments' tendencies to misuse laws originally intended to fight serious crime. This phenomenon is known as "surveillance creep." These laws generally reduce the burden to obtain evidence, obtain a criminal conviction, or seize property, so authorities naturally use the new law instead of older, more burdensome legislation.
Nor is surveillance creep limited to the United Kingdom. The USA PATRIOT Act, supposedly enacted to fight terrorism, is now routinely used in other types of criminal investigation. U.S. civil forfeiture laws, enacted in the 1970s to crack down on drug kingpins, are now used routinely to confiscate cash from unwitting motorists and others. No criminal conviction is necessary.
The only way to stop surveillance creep is to stop enacting laws that give governments carte blanche to take shortcuts in order to solve increasingly petty crimes. In the meantime, if you live in the United Kingdom (or anywhere else), beware of breaking even minor laws - because governments enact new legislation all the time that can be used against you.
MARK NESTMANN, Privacy Expert &
President of The Nestmann Group
www.nestmann.com
P.S. Read more about the largest "carte blanche" of all - the PATRIOT Act. Click here.
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