Monday, July 11, 2011


People are avoiding bank stocks because:

1. After the lending and investing policies of the last cycle, no one in their right mind can have any confidence in the ability of bank managements to manage over nearly any time frame.

2. Because of No. 1, the failure of laissez faire regulation and other factors, the entire banking industry is undergoing a change in its business model. Not only don't we know what the exact configuration will be but the change is not likely for the better.

3. The baking industry's high return on equity businesses (e.g., prop trading and derivatives) are being reduced in size or jettisoned completely. (By contrast, the traditional insurers are building up their high-return businesses)

4. Banks are now left with servicing the consumer, the residential/nonresidential real estate buyer (and seller), small businesses and large corporations. The consumer is screwed, however, and although the office sector is fine, the residential real estate market is inactive and double dipping in price. Also, small businesses are pressured by rising costs (and bankers are slow to lend in this sector), and large corporations are so liquid that they don't need the banks to the degree they have in the past.

5. Bank earnings have been buoyed by improving credit quality and a steep yield curve over the last two years. But credit quality improvement is fairly advanced (and comparisons will grow more difficult) while the yield curve can't be expected to be as steep forever. They have shortening half lives.

6. For some of the reasons listed above, loan demand remains weak.

7. Banking industry earnings power has been markedly reduced, reflecting the changing business model and the dilutive impact of equity raises.

The Spanish 30-year bond yield exceeds 6% for the first time since 1997.

"We need to stop being surprised by the continued weakness of job creation and start being prepared for it. We need to confront a changed global system and the place of the United States in it, as well as the challenges of future growth for what is on balance an extremely affluent society compared with the rest of the world. The cycles of the 20th century are not and will not be the cycles of the 21st. This time, it's different."

-- Zachary Karabell, Daily Beast ("Jobs Aren't Coming Back")

The mistake many have made and are continuing to make is that they view the jobs weakness of 2009-2011 as cyclical. It is not -- rather, it is a structural phenomenon. Employment will not resume (relative to bullish expectations and relative to past cycles) as the overall economy recovers.

The economy in the 21st century will not resemble the economy of the 20th century.

Public policy of throwing money at the jobs problem (quantitative wheezing) is misplaced. Nor will lowering tax rates for corporations and the wealthy help -- both groups have more than enough liquidity. Corporations, in particular, have never had more liquidity and more solid balance sheets, yet they are still not hiring.

So, from my perch, trickle-down economic theory is dumb theory -- it's yesterday's theory.

Indeed (with the benefit of hindsight), the policy of quantitative wheezing had adverse consequences in raising the costs of the necessities of life and by penalizing the savings class, placing more pressure on the middle class. (Screwflation of the middle class remains an important theme to the last decade and to the next 10 years.)

The wrong tools are being used to deal with elevated unemployment that is being influenced by new factors that include globalization, austerity, the shedding of municipal jobs (associated with local, state and federal fiscal imbalances), technological innovation and the use of part-time employees as a permanent part of the workplace, reflecting mounting health care costs and the costs of regulatory burdens.

Structural unemployment will be a consistent drag on domestic economic growth -- and, in the fullness of time, corporations will be victimized by lower demand for their products -- until authorities recognize the source of the secular problem and deal with it in a more focused and aggressive manner.

Investors will soon recognize that correcting our structural issues requires time and patience. When they finally do, share prices and valuations will be lower than they are today.

The notion of a self-sustaining and smooth recovery in the U.S. is in jeopardy and is now further complicated by the sovereign debt contagion in the eurozone, which, too, is being addressed by kicking the can in a temporary but not meaningful way.

In the final analysis, the budget impasse in the U.S. will be "resolved" but only with some more can kicking.

As to the U.S. stock market viewed as a leading indicator of growth, that is bogus, too. In 2002, 2007 and in the first half of 2010, the direction of the U.S. stock market gave the wrong signals on the direction of economic growth. Stated simply, the recent two-week rally in stocks is, too, giving the wrong signal of smooth and self-sustaining growth.

It should be noted, however, that sentiment has shifted to a more optimistic mood with advancing share prices:

* The AAII individual investor survey is at five-month high (42% bullish/26% bearish).

* The CBOE 10-day put/call ratio has fallen from 1.15 to 0.92.

* ISI's hedge fund study indicates a swift and sudden rise in net long positions in the past seven days (from 49.4% to 52.6%).