The banking sector regained some footing in late March and early April as shares of regional banks mostly stopped sliding. Stock prices reach equilibrium when buyers’ optimism precisely matches sellers’ pessimism. It is hard to find a balance while sellers are panicking, but eventually the panic runs its course. Now the optimists are noticing that small banks look cheap as long as enough capital remains available to ward off a shutdown by regulators.
Meanwhile, large national banks enjoyed a surge of deposits from customers fleeing middle market competitors. JPMorgan Chase reported record revenue in its first fiscal quarter, and management’s tone on the conference call was decidedly optimistic. The stock has already regained most of its March losses.
Disinflation, low unemployment, and rising workforce participation all fit the Federal Reserve’s ideal script, but there is reason for the Fed to stay frosty. Interest rate policy matches the economy’s present condition, but things can change fast, and there is risk in both directions. We hinted above at some reasons why inflation could be more stubborn than recent statistics imply. The Federal Reserve seems aware of these risks and has introduced strong language about inflation vigilance into its messaging. Meanwhile, what about risk in the other direction—the risk of overtightening? Interest rate policy works with a lag, and holding rates too high for too long could hypothetically cause unnecessary damage to both the financial system and the real economy.
In his 2022 letter to JPMorgan Chase shareholders dated April 4th, CEO Jamie Dimon argued that an inefficient and ever-expanding regulatory burden hinders banks’ ability to compete against more lightly-regulated “shadow banks” providing similar functions outside the banking industry. The result is that traditional banks play a declining role in the global financial system. Dimon’s implicit warning is that risk could be pooling in dark spaces where regulation cannot limit it. For example, institutional investors—sovereign wealth funds, pension funds, endowments, etc.—have for years been taking capital out of the public markets and the traditional banking sector in favor of private investments that are believed to offer higher returns with less downside risk. Critics often complain that private investments are quick to post gains when things are good but are slow to admit losses, creating a perception of high reward with low risk that only breaks down when markets turn down and stay down.
The recent banking concerns were driven by a combination of losses on bank assets, mostly because of higher interest rates, plus capital flight from depositors afraid of getting caught holding the bag when those losses came to light. The self-fulfilling nature of a bank run is well understood. Perhaps less well understood is that similar runs can happen outside the banking system whenever short-term lenders and investors start racing to claim a limited stock of liquidity.
The same shocks which recently whipped through the banking system may also be present in other corners of the financial system that are less transparent. A popular real estate investment trust recently limited the freedom to take redemptions. We have heard stories of cryptocurrency platforms limiting or refusing withdrawals. The turnstile lets you in but not out. Call it Hotel California risk.
We favor public markets. Although they are subject to investors’ whims, their quoted prices, however volatile, constitute a real offer to exchange securities for cash, or vice versa. Private valuations typically offer no such certainty. Investors may be fighting the last war when they worry about publicly traded banks, which are quite transparent to investors and even more transparent to regulators. The next financial crisis, whenever it comes someday, will look different. Pay especially close attention to weaker foreign economies for hints of where the risk is hiding. America’s economy may be top of the heap, but our exceptionalism only goes so far.
Investors should focus on buying and hold the best individual companies they can find for their portfolios, such as the three business profiled in the May 2023 issue of the Investor Advisory Service. Our analysts profiled three midsized companies in this issue: an energy services company, a transportation services business, and an Internet advertising firm. All three have the potential to thrive in the next five years, delivering above-average returns for their shareholders.
The commentary has been excerpted from the issue of Investor Advisory Service published in late April. To receive commentary like this in a more timely matter and receive actionable stock ideas each and every month, subscribe today. The Investor Advisory Service stock newsletter was named to the Hulbert Investment Newsletter Honor Roll for the 13th consecutive year for outperforming every up and down market cycle since 2002.
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