Tag Archives: financial sector

The problem with real returns

Our common sense understanding of investments is that they are supposed to offer us something in return for an initial outlay, in our case money.  Whether those gains are realized immediately or in several years, is something each individual investor has to think about and see if the particular project is worth going into, and we all seem to understand this notion as a real rate of return.

So when I saw the Wall Street Journal publish this article on real returns, I was a little puzzled.  My impression from going through many of WSJ’s articles was that a lot of the basic financial concepts are considered to be common-ground when trying to decide if market developments are newsworthy or just flashes in the pan; however, history seems to suggest that many investors might be misinterpreting what a real return actually is and paying dearly for it.

This notion seemed counter-intuitive at first, but upon glancing down the article, I found that the article talked extensively about the role inflation has played in the valuation of portfolios that are typically diversified.  It brings up the example of taking $10,000 and investing it at 10% a year for 20 years.  By the end of that time with no inflation, you would have roughly $70,000.  With 3.5% inflation, that $10,000 only hits $20,000.  Not a bad return by any means, but not what you would expect from a 10% annual return.  Based on this logic, if we used 1950’s trading volume as a baseline for what is considered normal, the Dow should be worth only 10,000 as opposed to the 16,400 it’s worth now.  Another explanation is that in the 1950s, on average stocks were trading at 11 times the previous year’s earnings and that was previously considered a clear sign of a booming bullish market; however, in 1982 prices were revised upward.  Since then, stocks have traded at approximately 18 times the previous year’s earnings creating a lot more bubble potential than ever before.

Does this mean that we’ve permanently revised stock expectations so that they will always be too high?  Potentially yes.  Forbes did an article last October on stock valuation, and they found that historical generational bull markets start when average price/earnings ratios based on the Shiller Index reached 7 or higher.  In 2009, widely considered to be the low-point of the recession, the average stock was trading with a P/E ratio of 14. This indicates a very bullish market by the Shiller index even though the exact opposite was occurring.  Upward revisions in trades have essentially rendered the historical Shiller index meaningless. After all the adjustment in 1982 was designed as a response to excessive inflation and probably intended to persuade investors to put their money towards stocks and away from highly inflated bond prices at the time.  Right now the economy is facing the opposite problem.  Inflation is still not close enough to the historical average and is only continuing to inch its way towards 2%, so that means high price earnings ratios should be treated with caution.  So the problem doesn’t appear to be just in an investors fundamental understanding of real rates of return, but it appears to be a systematic problem which has misled some investors into believing that almost every stock is strong based on a historical average.  This leads to unreasonable expectations, or a false-bull market and can often times lead to inefficient “flights to quality” like we saw in January.

 

Yellen Breaks the Ice

In her inaugural public appearance since becoming the central bank’s first chairwoman, Janet Yellen confirmed that her intention is to continue the policies of her predecessor (Ben Bernanke). According to the Wall Street Journal, “Her comments left little doubt that her plan – as was Mr. Bernanke’s – is to tiptoe away from those policies only gradually as the economy improves”. I agree that it is time to wind down the Fed’s unconventional monetary policy in which it conducts large-scale asset purchases. First, quantitative easing seems to have served its purpose of lowering long-term interest rates. Second, I still worry that we might face some undesirable consequences from quantitative easing down the road. Now that quantitative easing has fulfilled the intentions of its creators, it should be phased out sooner rather than later in order to reduce whatever unintentional effects might be looming in the future.

Although the continuation of the taper means a reduction in stimulus, financial markets responded well to the plan that Yellen outlined. Furthermore, I think financial markets were extremely pleased that Yellen appeared completely as advertised (meaning she performed as expected and without any surprises). According to the Wall Street Journal, “In two instances, she thanked lawmakers for calling her unexciting”. Yellen’s primary theme during her public appearance was predictability. Every detail of the presentation seemed to be planned perfectly. The financial markets are notably sensitive to everything, which includes what Yellen says and how she says it.

Yellen’s calm demeanor and clear rhetoric is exactly what everyone was hoping for and I think the financial markets were extremely pleased with the lack of surprises. According to the Wall Street Journal, “The markets, having anticipated a steady stance, greeted Ms. Yellen’s comments with approval”. As expected, Yellen will continue with the taper and not change the course of the Fed. Despite the two months of disappointing employment reports, the Fed will taper at the same pace ($10 billion reduction per month). Although financial markets rallied when the Fed surprisingly delayed the beginning of the taper last year, I do not believe the financial markets would handle such a surprise the same way today because tapering has already begun. Unless a significant problem develops in the economy, such a deviation from the plan set out only a month ago would signal a lack of confidence in the recovery. If the Fed was confident enough to announce the taper in December, then a departure from the taper only a month later would likely spook investors. Obviously, a major change for the worse would lead the Fed to dramatically change course. However, that event has not occurred yet and I hope it will never.

Yellen was so eloquent that she even managed to dodge the numerous questions she received regarding financial regulation. Although she did not provide any significant details, she seemed to defend and support the Dodd-Frank legislation. According to the Wall Street Journal, “[Yellen’s] comments suggest she’s likely to continue the Fed’s efforts to implement the 2010 Dodd-Frank financial overhaul in a way that places higher burdens on companies viewed as posing risks to the broader financial system. That could mean more capital and liquidity rules requiring the biggest banks to meet higher standards than smaller firms”. The implementation of Dodd-Frank has been a lengthy process with much scrutiny. On the one hand, some critics claim it is too tough and requires banks to hold too much capital. On the other hand, some critics claim it is too lenient and does not require banks to hold enough capital. In this situation, I am torn because I do not know the right amount of capital for banks to hold.

Currently, the additional amount of capital that banks are required to hold is already noticeable. For example, the return on equity for the largest financial institutions is down considerably. Although I understand that the intentions of Dodd-Frank is to avoid the next financial crisis, forcing banks to hold excess capital likely also restricts them from making loans and engaging in other activities that spur economic growth. I would imagine that Dodd-Frank will be shaped to keep American banks on the same page as European banks, which are subject to Basel III capital requirements. I think that it is in the best interest of the global economy to have similar global financial regulations. Otherwise the financial institutions of some countries will have a competitive advantage, but also be much riskier and be a potential danger to the global financial system. I look forward to how Dodd-Frank and other financial regulations are executed.

Big Banks & Moral Hazard

After the Great Recession, many economists cited moral hazard as the prime reason to not bail out failing banks.  Nevertheless, our country proceeded to bail out many major financial institutions in order to minimize the impact that widespread bank failures would have on the economy and equity markets.  Why?

The answer seems to lie in the level of influence financial institutions have on the US economy; it is extremely difficult to let banks fail because they constitute such a significant portion of the economy.  In the USA, for example, the financial sector produces nearly 10% of GDP (NYT: The Rich Country Trap).  Because financial institutions produce such a large portion of the nation’s GDP, they are extremely influential and important to this nations economic success.  Indeed, policymakers call upon the heads of financial institutions when they need help with the nation’s economic problems.

Nevertheless, if we want to reduce moral hazard, we must confront big banks.  In an IMF conference in 2013, Ben Bernanke stated that banks must be allowed to fail in order to eliminate the threat moral hazard.  That said, as the failure of Lehman Brothers in 2008 showed, bank failure can have devastating consequences on the economy.  As such, Bernanke believes that policy makers need to devise a systematic and controlled way for banks to fail.  This systematic failure should minimize the impact of bank failures on the economy.  While I do not understand the details of this systematic failure, my hunch is that Bernanke has proposed gradual bank failure, where failed banks slowly fall out of existence with the help of the government as opposed to dropping out of the economy at the onset of bankruptcy (Bloomberg: Bernanke Says Failing Bank Process Needed to Reduce Moral Hazard).

It seems clear that to avoid another bank collapse, we must reduce the effects of moral hazard.  Ironically, however, banks are so influential that many policymakers lack the guts to address the issue or moral hazard.  Consequently, banks continue to operate knowing that in the event of disaster, the government will likely come to their aid.  To address the issue of moral hazard, therefore, it seems that we must have a transition period, where systematic failure is implemented, bank regulations are increased, and moral hazard is reduced.  Naturally, during this transition period, bank profits and GDP will fall, and this fall in GDP will be painful.  But just like saving money, it will be beneficial in the long run; this transition period will reduce moral hazard while forcing banks to appreciate risk and operate in a responsible manner.

It will be very challenging to find politicians willing to take us through this transition period.  Certainly, politicians proposing a painful transition period won’t easily win the favor of voters.  Maybe, though, if we can sever the ties between political fundraising and banking, we may be able to elect such a politician.

Earnings in the Financial Sector

Although the U.S. economic recovery is still trying to gain momentum, some of the U.S. banks are bigger and earning near their record levels. J.P. Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley earned $76 billion in 2013. According to the Wall Street Journal, “That is $6 billion shy of the collective all time high achieved in 2006, a year U.S. housing prices peaked amid a torrid economic expansion”.

The strength in the financial sector is reflected in their stock prices. The Financial Select Sector SPDR, which is an exchange-traded-fund that tracks the financial sector, is at its highest level since before the financial crisis in 2008-2009.

Ticker: XLF

Ticker: XLF

Banks must continue their strong performance in order sustain their increase in share price. According to the Wall Street Journal, “Now that their stocks have run up so sharply, banks will have to perform well to keep share prices buoyant”. If they fail to meet expectations, they will likely watch their stock prices spiral downward. Thus, banks might undertake risky-decision making or other methods to juice earnings.

During the financial crisis, there were some high profile acquisitions by large U.S. banks that significantly increased market concentration. The consolidation involved stronger banks acquiring weak or failing financial institutions. According to the Wall Street Journal, “Wells Fargo, a West Coast institution that became a national presence after its 2008 purchase of Wachovia Corp., posted the highest annual net income in its 161-year history last year. Bank of America, which gained heft on Wall Street when it bought securities firm Merrill Lynch & Co. in 2009, had its best year since 2007, as revenue increased in all five of its major business units”. In the short run, acquiring failing institutions such as Merrill Lynch and Wachovia (that had massive amounts of subprime, toxic debt soon to default) depressed earnings. However, these acquisitions are clearly proving beneficial in the long run. With the losses already being absorbed, the banks can now enjoy the benefits of economies of scale and increased market share. The banking industry is more concentrated than before the financial crisis. High market concentration and massive barriers to entry in the banking industry creates questionable conduct in which banks are enjoying substantial earnings.

Another reason for near-record earnings is that the healthier U.S. economy is encouraging banks to hold fewer reserves to protect themselves against the possibility of borrowers defaulting. According to the Wall Street Journal, “J.P. Morgan, Bank of America, Citigroup and Wells Fargo freed up $15 billion in loan-loss reserves during 2013, including $3.7 billion in the fourth quarter. That money goes directly to the bottom line, boosting profits. The releases made up 16% of these banks’ pretax income for that final quarter”. The problem with this is that it means earnings are artificially inflated. In other words, this gain is unsustainable and does not reflect earnings from selling a good or service that is a part of ongoing business. When this unsustainable source of earnings disappears, banks will feel an incredible amount of pressure to find another way to juice earnings (or stock prices will likely fall).

The decision of these large U.S. banks to hold less loan-loss reserves is extremely controversial. According to the Wall Street Journal, “Some investors aren’t pleased that big banks continue to rely so heavily on improving credit conditions to pump profits. Regulators have warned the moves may be too aggressive, and that they are unsustainable. The reserves have added to aggregate earnings in every quarter for nearly four years”. Not only is the reduction in loan-loss reserves artificially inflating profits and creating increased expectations for future earnings, it makes me question quality in bank earnings.

The weakness in bank earnings is reflected in their return on equity (ROE), which relates the earnings of the firm to Owners’ Equity. An underlying assumption is that the earnings of the firm belong to the firm’s owners, which makes ROE a closely watched investment-performance ratio for stockholders. According to the Wall Street Journal, “Return on equity has been a problem for banks since the crisis, as regulators cracked down on risky, but potentially profitable, businesses and required financial firms to raise equity to make their capital structures safer”. Regulation is requiring that banks hold more capital rather than put that capital to work. In order to improve ROE, you cannot just increase sales. Rather you must increase the efficiency by which sales are generated. As the economy improves, investors are going to want ROE to improve and this is being made hard by strict financial regulation. This has promoted banks to reduce compensation, cut their workforce, and shed certain lines of business. Although financial regulation is designed to create financial stability, it is creating huge challenges for banks (reflected by a low ROE).