Sixty Guilders Research – Bank Stocks

Bank stocks have been murdered in 2016.

Why may you ask?, as we are home to the serial-build-sell banking industry. There are 3-4 main reasons for the acute nature of their drastic underperformance:

• Net Interest Margin squeeze;
• Bond Yields plummeting (prices up);
• Revenue & Earnings decline; and
• The Federal Reserve CANNOT manufacture economic growth.

Banks make money by charging a spread on money they lend – quite simple. When the slope of the Interest Rate Curve flattens bank earnings (by definition) decline, just like gravity. Avoiding mistakes is the general role of a decent banker.

Additionally, the disruption in the credit markets (lending to lower quality companies) decreases the willingness of banks to lend. As one banker recently told me, “the loans we want to actually make are so high quality the pricing is terribly competitive, so we make no real margin”.

Net, net – bank stocks do not perform well as the interest rate curve flattens (we have been pounding the 10 year – 2 year Treasury spread signal) and with an uncertain environment. Unfortunately, banking is often counter-cyclical and the biggest loans are made at market tops.

As banks have strengthened their balance sheets since the financial crisis this has resulted in reduced leverage, and as a result, return on equity has suffered. Therefore, reduced profitability from a flattening yield curve, has lead to not only an anemic return on assets (ROA at less than 1% for the banks we track), but also an inability to leverage this return to an adequate return on equity (ROE of 8.3% for our coverage universe of banks for the most recent year, and heading even lower going forward, in our opinion).

We do not recommend owning bank stock. However, in many cases the preferred securities and bonds of banks are quite attractive. We continue to like income securities into the face of a slowing macroeconomic environment.

Thank you for your interest in Forest Capital and Sixty Guilders Research.

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