Time to Make a Withdrawal

 | Mar 25, 2014 | 12:00 PM EDT  | Comments
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Stock quotes in this article:

c

,

nwbi

I recognize that there is a body of market participants who worship at the altar of price momentum.

Sometimes, however, when traders and investors blindly follow charts from the lower left to the upper right (hat tip Sir Denny Gartman!), those late to the party get burned, as has been the case recently with the biotech sector.

This brings me to the current infatuation with and rotation into money center bank stocks.

I own only two bank stocks: Citigroup (C) and Northwest Bancshares (NWBI).

Though the financial sector has recently perked up, one has to question the piling on.

I have spent my life following the financial sector -- I understand the group's profit dynamics.

I coauthored the book Citibank with Ralph Nader and his Center for the Study of Responsive Law in the early 1970s. And a few years later, while I was working for "The Chief" at Putnam Management in Boston, I spent five solid years researching the sector. (During that period, I was voted the No. 1 buy-side banking/thrift industry analyst by Institutional Investor.)

Banking industry profits are basically a function of several basic variables: the level of loan demand, FICC activity (i.e., trading in products tied to interest rates, corporate credit, mortgages, currencies and commodities), the trend in credit quality, interest rates and the slope of the yield curve.

Loan demand remains tepid, growing slowly. In part, this is a function of subpar economic growth, pressures (regulatory and expenses) on small businesses and the liquid state of the country's largest companies (which also have access to cheaper, public money).

FICC activity has contracted and has turned from being a tailwind to being a drag on bank industry profits.

Credit quality has been improving for three to four years. Loan-loss provisions have been consistently declining (and reserve releases have expanded), acting as less of a headwind to banking industry profitability in recent years. But the benefit of those non-operating factors is beginning to diminish now and will be less of a tailwind in 2014-2015.

Which leaves us to interest rates and the slope of the yield curve. This is the most important profit contributor and should be the most worrisome area for bank investors and bank profits, because it will likely put a limit on any improvement in net interest income (and margins).

Of late, while bank stocks have perked up, investors have been ditching short-term Treasury notes in favor of buying longer-term Treasury bonds. As a result, the slope of the yield curve (the difference between five-year and 30- year yields) is at the narrowest since 2009.

Below is a chart that exhibits the flattening of the yield curve.

Stated simply, this yield curve flattening portends disappointing net interest income (and margins) through the remainder of 2014.

And of all the basic factors contributing to banking industry profits, net interest income is by far the most significant contributor.

Some strategists and commentators in the business media count financial stocks among their favorite groups. Over the past few days, I have presented some of the concerns mentioned in today's opening missive to these folks, but they push back and say that the sector is inexpensive.

To me, there are numerous reasons why the banking group will not experience a further valuation upgrade -- the most important being the impact of legislation on operating leverage and profit sources.

For the banking industry, after nearly suffocating the world's economies in 2007-2009, it is different this time. Mandated leverage of "only" 12x-15x compared to over 30x (in certain cases) back then presents less profit centers and opportunities for the industry in the present and future.

As a result of these observations/analysis, I would not chase the current strength in the banking sector, and I would consider paring down exposure in light of the sector's recent share price advance.

Or as famously successful New York Stock Exchange floor trader Joe Gruss once told me, "Yell and roar and sell some more."


This column originally appeared on Real Money Pro at 8:40 a.m. EDT on March 25.

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