History doesn’t repeat itself—but it does rhyme.
From an investor standpoint, we’re going to spend a generation thinking in terms of the financial crisis, just as those before us thought of stagflation or the Great Depression.
That’s not a problem, at least as long as we recognize that bias that we’re subconsciously putting to work. When it comes to the financial crisis, no single sector sums up the trouble like banking.
Banking has been an unloved sector since the financial crisis. That makes sense. After all, during the peak fear, investors saw 80-90 percent declines in shares of big banks like Citigroup (C) and Bank of America (BAC). And those were just two of the “too big to fail” names that not only survived the crisis, but ended up in a stronger competitive position as a result.
But what’s overlooked about the banking sector are the smaller, community banks. These are banks that didn’t get into the high-risk speculative actions that the Wall Street banks engaged in. Rather, these companies stuck to the basics of banking. They made loans that they thought could be easily repaid. More importantly, they kept those loans on the book. There was no slicing and dicing mortgages into tranches or any of the other financial engineering that proved to be too clever when markets invariably started getting wonky.
That’s kept these banks boring. When it comes to investing, boring works. It’s where the value is, and where investors can get great returns without taking on a lot of risk. It’s also why community banks can pay investors yields of 4-5 percent at a time when most of the big names on Wall Street yield half that at best. It’s also no wonder that the total number of banks around the country is shrinking, as bigger banks buy out smaller but more profitable banks. That gives investors capital gains and an exit strategy for buying the baby banks.
As the 8-year anniversary of the current bull market has started, the word is finally out that the community banks are a bargain. Now they’re less of one. Since the election, community banks have rallied 30-40 percent, as seen in the First Trust Nasdaq Community Bank ETF (QABA). That’s even outperformed most of the too-big-to-fail crowd!
What’s behind the recent rally? Reform. Between tax and regulatory reform, the banking sector stands to gain a huge advantage over other industries. After all, they face some of the most regulations today. But the business of shuffling capital around is one that doesn’t require expensive depreciation industrial equipment or crippling pension obligations. No wonder bank shares have popped in recent months. Investors looking for a bargain should look elsewhere—or wait for things to calm down. They always do.
Over the longer-term, banks seem to be moving higher in line with interest rates. Now that the Federal Reserve has committed its third rate hike in a decade, a sense of a return to normalcy is supporting bank prices as well.
For now, that seems to work. Banks can squeeze borrowers for slightly higher returns, but can still be stingy about paying interest to depositors. At its extreme, it could pose a problem. Someone willing to take on a mortgage at 4 percent might now be permanently anchored to a low rate and balk at a more normal 7 percent. Time will tell how much lending is curtailed by these increases, but with rates still close to zero and with incremental increases of a quarter point, we’ve got a long way to go before that party ends. Chances are a recession will hit first.
What could take some of the recent wind out of the sails of the banking sector? There’s one quick way that we know of. Fear of another financial crisis-style meltdown. While I think it’s unlikely that history will unfold exactly the same way, it could be the case for one bank in immediate and possibly mortal peril.
That beleaguered firm is Deutsche Bank (DB). The German bank is at the epicenter of European capital flows. They’ve been impacted on every woe out of the EU in recent years from Greece’s first debt crisis to Greece’s latest debt crisis. A myriad of economically struggling countries under a one-size-fits-all currency faced with rising populist uprisings could lead to some big moves in the market—and crush this institution in the process.
The real issue is that, as part of the too-big-to-fail crowd, DB has a lot of derivatives on its books. Those side bets on everything from individual stock performance to the movements of interest rates might not sound like a problem. After all, in aggregate, many derivatives trades are designed to cancel each other out. But as the counterparty, a big market move in any asset could lead to wild swings in the bank’s valuation.
That’s why the company keeps ponying up to the equity table. They’ve been issuing more stock, watering down existing shareholders. They’ve been taking out debt as well. It creates the appearance of weakness at a seemingly terrible time.
During the financial crisis, shares got down to $25 before tripling off that panic low. But since then, they’ve been sliding, getting as low as $11 but trading closer to $19 today. For a bank whose pre-crisis price was closer to $150, and one that looked solid as a rock, investors in the past decade have lost 90 percent of their wealth. More if you count inflation.
Where does all this leave investors? In one sense, the banking sector feels a lot like it’s been stuck in neutral—or worse—since the financial crisis.
But there’s a real opportunity to buy smaller banks at the right price. That right price isn’t here at the moment following a big rally. But it could be, and rather quickly, if we see another financial-style meltdown occur. That’s the time to buy the good banks.
The sector, while looking attractive based on recent moves, is susceptible to a pullback. While it may look tempting, better values will emerge.
Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and writes the monthly newsletter Crisis Point Investor.