Exactly three months ago on January 18, our Market Commentary discussed whether or not it might be time to increase exposure to bank stocks. We noted that following several years of dramatic underperformance, the sector had begun to outperform. We suggested that the recent strength in the sector had been due to 1) super-cheap valuations; 2) an improvement in fundamentals and earnings visibility; and 3) increased clarity with regard to a number of risk factors. We provided a list of positive developments that underpinned the strong relative performance for the sector. And we concluded by saying that the recent strong relative performance seemed likely to continue:

“As issues get cleared up, one by one, investor reticence with regard to bank stocks should continue to decline. We once again quote Joe Rosenberg, Chief Investment Strategist at Loew’s: “You can have cheap equity prices or good news, but you can’t have both at the same time.” In other words, it will be too late if we wait for all the risks and uncertainties to clear up. Bank stock valuations will have already risen to reflect the improved outlook.”

“As long as the visibility surrounding future bank earnings power continues to improve, we would expect valuations to improve and bank stocks to continue to perform well relative to the overall market. After the recent increase in prices, earnings disappointments or other bits of adverse news will likely cause setbacks. Those strike us as near term issues which may add to volatility but should not derail clear, albeit plodding, long-term progress.”

Since we wrote those comments early in the year, the Financials sector has been the best performing of the ten S&P 500 sectors (+13.4% versus +5.9% for the overall index). The Financials are now up 31.3% compared to just 19.3% for the overall market since the beginning of the current market rally on November 23, 2011. The dramatic rebound in bank stocks is a reflection of just how depressed the sector had become. So has the opportunity passed, or should we continue to expect outsized gains from the sector?

In our estimation, the strength in bank stocks to date has been almost entirely due to a correction from oversold valuation levels. As credit losses piled up following the financial crisis, many investors had simply deemed the sector too risky for consideration. Now that credit losses have improved, the housing market has stabilized, balance sheets have been made stronger, and regulatory issues are more clear, money has poured back into the stocks. This renewed investor interest was completely justified simply based on valuation. But this does not mean that fundamentals are back to normal for the sector. Recent increases in bank earnings have been highly dependent on lower credit losses. Banks continue to suffer from a large backlog of mortgage foreclosures, high loan servicing costs, margin contraction, weak loan demand, and outstanding regulatory issues such as the Volcker Rule. Until fundamentals improve, investors are unlikely to award the banks historical valuation multiples.

In other words, the low-hanging fruit has likely been harvested at this point. Further material gains in bank stocks will likely result from a return to industry health rather than the elimination of risk factors that had previously weighed down the sector. Banks cannot achieve earnings gains indefinitely from lower credit losses (or higher mortgage origination income, for that matter). These are lower-quality sources of income for banks, and the market does not assign as much credit as it would to spread income from loans, for instance.

Our base case scenario continues to call for a slow-growth environment as the consumer continues to delever, employment gains remain slow, and fiscal and monetary support is slowly removed. Under this scenario, loan growth, fee income growth and interest rate increases (which will help bank margins), are likely to be muted. If we are correct in our economic forecast, it might make sense to pull back a bit on the bank stock exuberance.

Peace,

Michael

Following steady gains for most of the year, stocks are experiencing a bit of a sell-off today. The major market indices are down over 1% as the “risk trade” comes off, at least temporarily. As expected, we are seeing the heaviest selling among the more cyclical sectors - Energy, Materials, and Financials - that have run up the most in recent months. So are we seeing the final throes of the 100%+ run since the lows of March, 2009, or is this just a healthy pullback for a bull market that remains in tact? While we cannot definitively say, the selling does provide evidence to support two of our concerns about recent investor exuberance. First, the stock market has become heavily dependent on easy money from the Fed. And second, the problems in Europe have not yet been solved.

A quick glance at recent bond market action in Europe shows that investors are yet again becoming jittery. Most of the recent press has focused on Spain, which is a much bigger economy than either Greece or Portugal. An auction of Spanish government debt last night was met with disappointing demand, and yields rose. Investors are dissatisfied with the country’s budget plan for 2012, which was released on March 30 and calls for spending cuts insufficient to meet previous deficit targets (5.3% of GDP). It did not help that Prime Minister Mariano Rajoy said publicly today that “Spain is facing an economic situation of extreme difficulty, I repeat, of extreme difficulty, and anyone who doesn’t understand that is fooling themselves.” As the chart below shows, yields on European debt have been rising in recent weeks, with yields on Spanish debt now close to highs for the year.

Back home in the US, yesterday we received the minutes from the Fed’s most recent meeting. The minutes revealed that fewer Fed members are now calling for additional monetary easing in the form of “QE3″. The reduction in support for additional action reflects the improvement in economic data since the last Fed meeting, including strong gains in payrolls, gains in manufacturing, and improved confidence among both investors and job creators. It is obviously ironic that better economic data is met with a sell-off in stocks. However, this is the situation the Fed has created. Encouragingly, several Fed members already recognize the problems created by this extended period of easy money. Richmond Fed President Jeffrey Lacker said today that “The logical time to raise interest rates is going to be sometime next year.”

In last week’s market commentary, we tried to show how addicted the market has become to ever-increasing amounts of cheap liquidity from the Fed. For many months we have been warning that Fed policy has created the risk of asset bubbles and moral hazard, especially in the stock market. In our view, it couldn’t be more clear that traders have been investing based more on prognostications of future Fed intervention than on pure fundamentals. This needs to change before we can finally put the financial crisis and Great Recession behind us. Yesterday’s Fed minutes were, perhaps, the first step.

So, without question, the waters remain choppy. We are hopeful that today’s market action is simply a reaction to the reality that the Fed will stand pat for now rather than engage in QE3 (for which some probability had been baked into share prices until yesterday). In any event, and despite the hole the Fed has dug and the continued problems in Europe, we continue to believe that high-quality, defensive stocks remain attractive in this environment. In fact, there is enough long-term value to be realized among large-cap, blue chip multi-national companies that one need not get aggressive and swing for the fences. While the hare may be first out of the gates, the tortoise is likely to win this race.

Peace,

Michael

There has been a lot of talk in the media (including from me) about the effects, both positive and negative, of the Fed’s aggressive monetary easing programs. We are in the camp that believes Fed’s support was unquestionably needed during the throes of the crisis in order to avoid a complete financial collapse. However, the continued aggressive monetary support from the Fed has led to some serious concerns, at least on our part. Our major concerns, as we have articulated in past market commentaries, are that 1) the Fed’s actions can cause commodity price inflation, which can be counterproductive to the recovery; 2) the Fed’s policies can cause asset price inflation, leading to the threat of asset bubbles; and 3) both the economy and capital markets have become heavily dependent on continued aggressive Fed actions, potentially creating a problem of moral hazard (particularly in the stock market). Our overriding fear is that the Fed will find it very difficult to extricate itself from the situation of dependence it has created. And while stabilization in housing prices and huge gains in stocks feel good at the moment, this could all change very quickly. The Fed cannot simply manipulate interest rates and grow its balance sheet indefinitely. What is the exit strategy? When does it begin?

In an effort to better understand the effects of the Fed’s monetary policy, we constructed a timeline of major Fed developments and tracked key economic metrics. We tracked five metrics or indices: the Dollar Index, the price of oil, a commodity index, the S&P 500, and the yield on the 10-year Treasury note. Our starting point was the announcement date of the Fed’s first quantitative easing program (”QE1″), and our ending point was late February of this year. The rather busy chart below shows the results of our analysis. The boxed annotations represent key developments at the Fed. The shaded gray areas on the chart represent periods during which the Fed had withdrawn QE support only to return later with more QE. Take a minute to review the chart, and we will try to draw some conclusions below.

Some conclusions seem pretty clear from the table (even though correlation is not necessarily causality):

1) The ballooning of the Fed’s balance sheet has contributed to a 17% decline in the value of the dollar versus a basket of other currencies;
2) The QE programs seem to have, at the very least, contributed to the sharp increases in commodity prices;
3) QE has been very kind to stock investors, and stocks performed far better during periods of QE support as compared to during periods which the Fed had withdrawn its QE support (gray shaded areas);
4) The sharp drop in yield on the 10-year Treasury note (down 41% during the measurement period, which is the objective of QE) occurred entirely during periods of withdrawn QE support.

The first three conclusions are consistent with our worries articulated above - the Fed’s programs seem to have at least contributed to both commodity and asset price inflation, and the stock market, at least, seems to be highly dependent on Fed support. The last conclusion, however, is potentially more worrisome. The fact that interest rates plummeted during periods of withdrawn QE support may be telling us that the economy is not strong enough to stand on its own two feet. Given that many people regard the bond market as better “tea leaves” than the stock market, it should come as no surprise that Bernanke remains fully committed to his aggressive monetary stimulus initiatives.
The problem is that there is no way to definitively know whether it is yet safe to take of the training wheels. Each time the Fed has withdrawn to date, the economic outlook appeared to deteriorate significantly. This has left Bernanke in a state of fear, believing he needs to stay fully engaged. However, it is quite possible that another factor was responsible. The crisis in Europe created an inordinate amount of uncertainty and pessimism during the summer of last year. To the extent that the liquidity crisis has eased, might this provide Bernanke with an opportunity to reduce the pressure on the accelerator?

In my opinion, we are rapidly approaching the moment whereby the risks of continued monetary support may outweigh the benefits. Several Fed governors, including Charlie Plosser, Jeffrey Lacker and Richard Fisher, seem to already agree with me. These Fed officials seem to understand that the longer we wait, the harder it will be to unwind. We hope that Bernanke will soon catch on as well.

* The “Dollar Index” is the PowerShares DB US Dollar Index Bullish Fund, an exchange-traded fund designed to replicate being long the US Dollar again the following currencies: Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona, and Swiss Franc.
** For “Oil” we used the WTI Cushing Crude Oil Spot Price as reported on Bloomberg Financial.
*** The “Commodity Index” is the PowerShares DB Commodity Index Tracking Fund, an investment fund with the objective to reflect the performance of the DBIQ Optimum Yield Diversified Commodity Index Excess. The Fund invests in commodities such as Light, Sweet Crude Oil, Heating Oil, Aluminum, Gold, Corn and Wheat.

Peace,

Michael