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Jeff Saut: Ebb Tide for Banks


Financials' 28-year tide flowing out.


Editor's Note: The following article was written by Raymond James Chief Investment Strategist Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

First the tide rushes in
Plants a kiss on the shore,
Then rolls out to sea
And the sea is very still once more.
-Ebb Tide (Righteous Brothers)

Hanging on the wall of my office is a plaque. The inscription reads "Financial Mania." Above the inscription resides an old 45-speed record titled "Runaway" that was a hit song recorded by Del Shannon in 1961. The plaque was a gift in honor of a strategy report I penned in the 1980's talking about the financial mania that was about to take place, likely causing a "runaway rally" in the stock market. It was a heady time as Paul Volcker had raised short-term interest rates to a yield-yelp high of over 20% in order to choke off the pervasive double-digit inflation. Our sense was that Mr. Volcker's actions would be successful, thus allowing interest rates to decline, which in turn would usher in an age of financial mania that would carry the equity markets substantially higher.

Reinforcing the financial mania theme was a series of events that would change the financial landscape for decades. Indeed, the age of financial deregulation began in the early 1980's with the implementation of the Depository Institutions Deregulation and Monetary Control Act.

Banks were now able to compete against brokerages and insurance companies. Credit unions began to flourish to compete with banks. Best known: Sears, Roebuck and Co. took advantage of deregulation during this time by offering financial services, including the Discover Card credit card, at its many retail locations.

Stocks subsequently took flight with only "the crash" of 1987 interrupting their upside stampede. The financial mania accelerated in the 1990's as worldwide deregulation began. Accompanying the financial engineering (our Japanese friends would call it "zaitech") were international trade booms and new trade agreements. Additionally, technological advancements created new business efficiencies. Emerging markets took off as said events allowed the instantaneous movement of capital, driving an influx of foreign investment into nascent markets.

In November of 1999, the Financial Services Modernization Act was signed into law, which seemed to mark the peak of financial deregulation. Beginning in the early 2000's, financial re-regulation began to trickle back into the financial industry after a series of corporate scandals shook the investment world. And with the signing of the Sarbanes-Oxley Act of 2002 (SARBOX), a broad law that encompasses 11 criteria ranging from accounting oversight to analyst conflicts of interest, the process of re-regulating financial institutions began.

We revisit these series of events because currently the media are replete with the question, "Is now the time to buy financial stocks?"

I did a number of media appearances last week and the question du jour was, "Do we buy Citigroup (C) on today's awful earnings report?" My answer was that focusing on individual bank stocks might be a bit myopic when the potential "real" insight is that the past 28 years of financial market deregulation has reversed. Plainly something has changed, and changed materially. To be sure, the tidal wave of zaitech-ism began reversing with SARBOX and the reversal has been accelerating ever since. Recently the ebb tide has turned into a "rip tide" as the spider web of financial engineering was exposed by the collapse of many toxically-structured investment vehicles (SIVs, SPIVs, VIEs, etc.) and punctuated by Bear Stearns' (BSC) bouleversement (BSC). Consequently, the tide is now flowing "out" after nearly three decades of financialization, which will no doubt crimp financial sector profitability with a concurrent "hit" to PE multiples.

Ladies and gentleman, investing environments tend to change at the margin. Yet since life can only be understood in retrospect but must be lived going forward, most investors fail to notice tectonic changes until it is too late. The current case in point is that I've avoided large capitalization banks for years, and continue to avoid them, since their fate was sealed when financial deregulation ended. Here is what the brilliant Peter Bernstein recently had to say on the subject:

"Three months ago, we wrote, '[T]he economic malaise will not be brief, even though its depth is uncertain.

The process is going to be like water torture, drip by drip by drip over an extended period of time, until all these excesses are squeezed out of the system and new and happier horizons can open up. This metaphor should now form the basis for all decisions, strategies, and analysis. Recessions matter, but the important features of the problems faced by the American economy are not in the short run. The crucial issue is the nature of the new longer-run environment that we are convinced is now a reality. This environment is still in its infancy, but its principal features are already identifiable. Too few people are thinking along these terms.

Since the 4Q'01 I've repeatedly spoken of a sea-change, commenting that the beneficiary of said change was likely the "stuff stocks" (energy, timber, cement, water, electricity, agriculture, base/precious metals, etc.) driven by the demand metrics from the "Chindias" of the world.

How long this trend will potentially last can be seen in the chart below.

Click to enlarge

Surely there will be slowing growth "scares" that will cause inevitable pullbacks in this theme, but longer term the trend should extend. And last week was just such an occurrence as many "stuff stocks" retreated, while conventional stocks rallied. Fortunately, we anticipated such a short-term sequence and positioned accounts accordingly. Our short-term strategy has remained steadfast in that we thought the S&P 500 (SPX) would break out above the February "highs" and scoot into the mid-1400's. From there we expect a decline that will be measured by "if" the U.S. economy enters a recession (we doubt it), and then whether that recession is shallow/short, or long/deep. Whatever the result, we think trading positions should be "scale sold" into ANY blue-heat upside-type hour above 1400 on the premise that there should be a subsequent decline irrespective of the economic outcome.

The call for this week: The lyrics to the song Ebb Tide read like this: "First the tide rushes in; Plants a kiss on the shore; Then rolls out to sea; And the sea is very still once more."

Unfortunately, I think the tide is now going out for many of the financial stocks after nearly three decades of financialization, which should crimp the sector's profitability with a concurrent compression of PE multiples. The quid pro quo is that I believe the tidal wave has rolled on to "stuff" and that wave has a long way to go.

Deregulation and Stock Returns Forecast Chart

If I'm correct, Alaska's vast amount of undeveloped natural resources will eventually be developed. A circumvential "play" on this is 7% yielding Outperform-rated Alaska Communications (ALSK). And don't look now but last Monday the 10-year Treasury Note (TNX) was yielding 3.43%, but at last Friday's high was yielding 3.85%, which is pretty strange action in front of the widely anticipated recession. Indeed, curiouser and curiouser.

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