A Long Course on Why You Should Be Short Financials

A Long Course on Why You Should Be Short Financials
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*     There is no market sector that has been as embraced as heartily as financials

*      But, the domestic economy is slowing, the Trump regulatory and fiscal policy put may be waning, the yield curve is flattening, interest rates are contained, protectionism is rising around the world and bank valuations are back to pre-crisis levels.
*      Sell financial stocks.

"Skepticism is the chastity of the intellect; do not surrender it lightly."

--Richard Fisher's mother (Richard is the former president of the Federal Reserve Bank of Dallas)

Group stink has never been more conspicuous than in financial sector stocks -- banks, brokerages and selected financials.

A day does not go by in the business media that a talking head doesn't exclaim his or her adoration for financial stocks. That view is typically underscored by self-confidence and total disdain and lack of respect for the contrary view.

But financial stocks, despite their popularity, already are starting to weaken and potentially roll over in the face of growing threats that few are heeding. The weakness recently been most conspicuous in life insurance and brokerages; it now may be floating into banking stocks

The Economy Is Likely Weaker Than Many Believe

*     Forgotten by the bullish cabal is that zero interest rates have pulled forward a great deal of economic growth and a large amount of debt that is growth-deflating has been created over the last eight years.

*     Positive economic surprises are moderating:

*     The yield curve remains flat and 10-year and long-bond yields have been contained and have not broken out of the existing range.

*     Commercial and industrial loan growth is moderating

The evidence continues to mount that the U.S. home market has reached an inflection point in price and activity. Housing remains a meaningful source of revenue for the commercial banking industry. Mortgage rates have surged to a three-year high. Thanks to higher mortgage rates and elevated home prices -- in part buoyed by institutional buying of homes to rent -- affordability has stalled and is at a post-crisis low. Home prices in affluent areas on the West and East coasts are moving lower, which typically presages a down residential housing cycle. The South Beach Housing Bubble is causing a collapse in Miami home prices that has now spread north in Florida. On my block in Palm Beach, there are eight homes for sale; six months ago there were none!

Speculation in homes is back, with investor/speculator demand totaling an outsize 37% of all transactions last year, according to housing maven Mark Hanson. Home flipping, which marked the end of the last cycle, is even accelerating.

However, institutional demand for single-family rentals is off sharply and several institutional investors have announced plans to liquidate homes owned. Meanwhile, foreign capital that buoyed the high-end housing markets is no longer inundating our markets, especially in Silicon Valley and other markets that depend on holders of H1B and EB5 visas. Finally, natural/native new-home buyers are saddled with record amounts of student , auto and credit-card debt and have been sidelined indefinitely as home purchasers.

Retail is undergoing an existential crisis as the channels of distribution change violently, but the problem facing retail likely runs deeper.

Auto sales are peaking. As incentives move to multiyear highs, the inventory-to-sales ratio moves back to 2007 levels and auto paper delinquency rates deteriorate further. Last week I spoke to five large regional auto dealers; it's bad out in the field. The bottom line is that the industry's activity likely will surprise to the downside over the balance of the year. (Despite the low price/earnings multiples of the auto original equipment manufacturers, General Motors (GM) and Ford (F) remain vulnerable).

Protectionism is spreading around the world. With it will come a reduction in trade activity, a source of banking income.

The European banking industry remains in disarray and, despite protestations from the bullish cabal, the European economic recovery remains fragile. See the Deutsche Bank (DB) post below. There could be collateral damage to U.S. banks. Yesterday Mark J. Grant wrote:

"I have a sense that, for Europe, it is going to be "Apocalypse Soon." This is not a guess, I never guess. I arrive at my conclusions with rational deductions utilizing sixth level thinking. I may not always be right, and I may not be right this time, but my thought process is clear enough. Neither do I have any axes or prejudices. I do not arrive at any investigations with any premeditated conclusions...

You can logically look at "fundamental analysis" and reach certain conclusions. You can ride the "Muddle Through" wave and investment in the European banks and other European companies. Many institutions, obviously, are doing just that. I, however, think that the "event driven risk" in Europe will overshadow the "fundamental analysis" soon.

I think, as Homer stated, that the "hook is coming for the crook." Plenty of those bad boys in European politics these days.

I see way more risk than reward in Europe now. Perhaps I am being overly conservative? Perhaps I am missing some opportunities? If I err, it is on the side of caution. I can live with my choice and sleep quite soundly.
Can you?"

--Mark J. Grant, Jeter les Vagabonds (March 20, 2017)

Valuations of bank stocks have returned to pre-Great Recession levels. Much must now come to pass for the stocks to outperform.

The "hockey stick" recovery in bank industry profits -- based on a steepening yield curve, higher interest rates and regulatory relief -- may be an illusion. 

Is the Trump (Regulatory) Put Dying?

"My view is that the fiscal path and regulatory reforms coming out of Washington .. are likely to provide a lesser and later contribution to economic and profit growth that the consensus expects."

--Doug Kass

The Trump health initiative appears to be foundering, the travel ban has been determined to be unconstitutional by the courts (twice) and the banking regulatory reforms may be put on the back burner, in part because that the president uncommonly has picked fights with the former president (Obama), German Chancellor Angela Merkel, China and others.

Today the Gallup Daily Tracking Poll showed the president's approval rating is an historically low 37%.

Bottom Line

"Non sono interessati a preservare lo status quo; Voglio rovesciarlo ".
("I'm not interested in preserving the status quo; I want to overthrow it.")

--Niccolò Machiavelli

Optimism seen in financial stocks over the last nine months in and of itself is not dangerous, but risks are being ignored and chances of disappointment have expanded as optimism in the sector has multiplied.

Despite the vigorous market advance in the last few months, my financial shorts, in the aggregate, are now profitable.

Though I remain long and enthusiastic about Hartford Financial Services Group (HIG) (and recently added to it), I have emphasized life insurance stocks (such as Lincoln Financial (LNC) and MetLife (MET) ) and brokerages (such as Goldman Sachs (GS) and Morgan Stanley (MS) ) on the short side. It may now be time to increase the size of my small banking shorts in Citigroup (C) , Bank of America (BAC) and JPMorgan Chase (JPM) as well.

Doug Kass is president of Seabreeze Partners Management Inc. 

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