hile technology
stocks grabbed the market’s attention this year, it is bank stocks that
have stood out during the last twelve months. The large banking
institutions provided yet another fillip for their owners in late
June — as some of them increased rewards to shareholders by substantial
amounts — all with the imprimatur of the Federal Reserve. Dividends went
up significantly — in one case by 100%. In the name of “returning capital
to shareholders,” the banks announced large stock buybacks as well.
Buybacks, most often made at high prices to boost stock prices and the
value of management compensation schemes, might, for once, actually make
sense. Even after making significant gains, many bank stocks were still
selling for less than accounting “book value” (net worth) per share,
which can be an indicator of depressed valuation. Banks typically sold
for about two times book value prior to the financial crisis.
In some ways
banking is a unique business, which, done well, is highly profitable;
done badly it is prone to disaster. At its core it acquires funds on a
short-term basis (bank CDs for example), and then uses that money to
make long-term loans (e.g., 30-year mortgages) and investments. Since
long-term interest rates are normally higher than those on the short
end, banks earn a “spread” on the difference. However, there is a risk
inherent in this arrangement. Since long-term loans “reprice” (adjust to
changing market interest rates) more slowly than short-term obligations,
banks are at risk of seeing their funding costs (those CDs) rise more
quickly than the income from their earning assets (the mortgages). The
situation can be further exacerbated if the loans are made recklessly
and the bank does not earn what it had expected, or worse, never gets
its money back. Well-run banks hedge these risks by holding adequate
amounts of capital as a cushion, and by making loans in a careful and
prudent fashion, i.e., lending money only to people “who don’t need it.”
Well-run banks are not in the
business of lending to high-risk borrowers or taking part in ventures;
that is the province of Wall Street and venture capitalists.
The recent history
of the banking business suggests a reason for the renewed interest in
bank shares. Too many of the larger institutions had forgotten what
being “well-run” meant. As a consequence, banks were at the epicenter of
the world financial crisis that began ten years ago and nearly crushed
the international financial system. Too much debt, seedy loans, and
shaky investments led to the collapse of a few major institutions (most
notably Lehman Brothers), with many of those remaining requiring
taxpayer support totaling hundreds of billions of dollars. In the
aftermath of the crisis, regulators subjected the banks to more
stringent oversight, and legislators restricted the scope of bank
activities with the goal of forcing banks to increase their capital
cushions to make them more resilient and prevent future taxpayer
bailouts. Dividends were slashed and any sort of payment to shareholders
was supervised. Activities that might deplete capital, such as
speculating in securities for the bank’s own account, were targeted by
legislation such as the “Volker Rule.” The fact that U.S. banks in the
aggregate had to pay tens of billions of dollars in fines and other
penalties goes to show the extent of the unwise and often illegal
practices that had permeated the industry. The banks had brought
opprobrium, and the increase in oversight that they abhor, upon
themselves.
As part of the
increased scrutiny, for the past several years the Federal Reserve has
subjected the country’s largest banking groups to annual “stress tests”
designed to gauge their ability to withstand a future financial crisis.
A few banks stumbled along the way, but all passed this June’s review,
which subjected the institutions hypothetically to a withering crisis
which included a stock market collapse and high unemployment. All came
through with their capital cushions intact. In addition, the Fed
approved banks’ “capital plans” permitting the increased dividends and
stock repurchases so appreciated by investors at quarter’s end.
While the
regulator’s verdict was certainly good news for the banks, it had
already been anticipated by the market. Share prices for many of the big
banks had appreciated substantially, often in the 50% to 100% range.
Boosting the growing positive sentiment towards the sector was the
belief that its regulatory burdens would soon be lightened, and that
fiscal stimulus programs expected out of Washington would boost loan
demand and lift interest rates, thereby improving profitability by
increasing lending spreads.
Following the
release of the stress test results in June, the financial media devoted
much attention to Warren Buffett’s Berkshire Hathaway, which had already
made $18 billion from an initial $13 billion commitment to banks.
Buffett famously supplied tens of billions of dollars of capital to
financial institutions during the crisis and its aftermath, in the
process becoming the largest shareholder of two of the biggest banks in
the world. Being capital rich in the middle of a crisis permitted
Berkshire to drive hard bargains, and some have maintained that Buffett
obtained “special” deals unavailable to anyone else.
This was not entirely the case, however. Bank securities traded
freely in the public markets and anyone could have purchased them,
sometimes at prices as good or better than the ones Buffett obtained.
That few emulated
Buffett at the time was largely due to fear. Banks were indeed
frightening entities: they had suffered large losses, and there were
fines, large legal settlements, stress test failures, new regulations,
etc. The economic environment of low interest rates was of concern as it
made it more difficult for banks to earn their way out of difficulty.
Additionally there was the institutional investor fear of poor
“performance,” that precluded getting involved in a sector with
questionable prospects. Some even feared for banks’ viability; perhaps
there was more trouble lurking within their balance sheets.
For all of these
reasons few investors were willing or able to take the long-term view:
banks had been through the wringer, but with more capital, restrictions
on speculative activities, and new managements, they were now different
and safer institutions. Economic conditions would eventually become more
favorable, allowing their earning power to come through. As for
“performance,” it was now possible to buy bank stocks so cheaply that
good returns were possible even if they were years in the making.
Eventually this vista of possibilities opened more eyes to the potential
of looking beyond current difficulties.
The expected higher
interest rates never did materialize. The promised stimulus package has
yet to be enacted. Events abroad have also reinforced a tendency to
lower rates. Europe and Japan (which have themselves experienced
negative interest rates over the last year) are still pursuing
substantial monetary stimulus programs, forcing “yield refugees” from
those lands to seek higher returns in the U.S. Sabre-rattling in various
hotspots around the world is a source of “safe haven” buying. The
resulting demand for U.S securities helps to keep our rates low.
Meanwhile, our
Federal Reserve policymakers continue to pursue a policy of higher
short-term rates (the rates over which they have the most control), as
part of a goal of returning to policy “normalization” after being in
crisis recovery mode. The resulting flattening of the “yield curve” as
short-term rates rise and long-term rates stabilize or decline has some
observers worried. A narrowing of the difference between long and short
rates has historically presaged economic downturns. Whether the
extraordinary monetary policies since the crisis have reduced the
usefulness of this indicator remains to be seen.
Interest rates were
not the only thing that prognosticators got wrong in this year’s first
half. At the beginning of
the year speculators (mostly hedge funds) had amassed a record bet on
rising oil prices. Following the collapse at the end of 2015, the
commodity’s price rose strongly to the low to mid fifty dollar range by
the end of last year, at which point it stalled due to rising U.S.
“shale” oil production. Frustrated with the persistently low prices, oil
producing nations agreed to cut their output in order to reduce the
global inventory glut brought on by their prior policy aimed at shutting
down those shale drillers. Encouraged by the prior price momentum, and
by oil producers’ restraint, traders bet on continued price increases,
only to see their dreams of lucre evaporate.
As so often happens
in finance and the markets, when many players pile on to the same
position, the opposite occurs. Oil prices declined. Those shale drillers
did not go out of business entirely; instead, the survivors got more
efficient and their production grew. Other producers, such as Libya and
Iran, increased output as well. The wished-for inventory reduction
occurred only slowly, if at all. Market players have now accumulated a
large short position in oil, betting the price will continue to decline.
We have always
maintained that a long-term perspective is the prerequisite for
successful equity investing. Those possessing the patience to adhere to
this position continue to reap the rewards as the stock markets are now
into the eighth year of the second-longest bull run in history. The S&P
500 equity index has posted gains for seven consecutive quarters, and
the first six months of 2017 proved to be the best first half of a year
since 2013. Since the market bottom in 2009 we have experienced armed
conflicts, currency crises, terrorism, political instability, and a host
of other challenges severe enough to unsettle financial markets and
investors. The fact is, change, turmoil, and the like are inevitable
facts of life. Through this tumultuous period, businesses in the
aggregate continued to prosper, and long-term shareholders were
rewarded.
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