Stay Away from U.S. Banks

Good advice, right?

Financial stocks are, once again, the scourge of Wall Street. There is talk of new financial regulation, rumors that the big banks will be broken up and sold, criminal investigations, and concerns about bad debts in Europe - all of which are making headlines daily. Will the horrors never end?

Professional money managers have been busy writing articles with frightening headlines, warning you that financial stocks are dangerous and to avoid them "at all costs." Yet, at the same time as they have been telling you to stay clear, they have been buying a lot for themselves.

Institutional ownership of Bank of America is 56%, Wells Fargo 75%, Morgan Stanley 75%, and Goldman Sachs 72%. For comparison, institutional ownership of Wal-Mart is 36%, Exxon 49%, Proctor and Gamble 58%, and General Electric 50%. If you want to have some real fun, go to the disclosure section of any article that tells you to sell stocks, and check the author’s holdings. You may find that while the author is telling you to sell certain stocks, the disclosure reveals that he owns them all. So yes, he does indeed want you to sell your stocks - so that he can buy them from you.

Here are the major reasons why financial institutions are set to outperform long-term:

The U.S. housing market
In 2008 and 2009, the price of real estate was plummeting, taking the net worth of the average American down with it. But prices have now stabilized, and at extremely low levels. The painful de-leveraging of America is over. The U.S. now has some of the most affordable housing in the industrialized world, and it won’t stay that way forever.

Client Purges
In the previous two years, numerous clients of major banks received letters telling them, for example, that their line of credit would be cancelled if they did not use it within the next 90 days. Clients were outraged, and many cancelled their cards just out of spite - which is was exactly what the banks wanted. This was money that the banks could have been lending out for a profit, but that was instead locked into credit with customers who would never use it. The banks, from their perspective, got rid of a lot of dead weight. They also got rid of a lot of credit risk.

Restructuring
During the height of the financial crisis, the industry was shedding 39,000 jobs every month. Although layoffs can hurt good employees as well as bad, it can safely be said that the best, brightest and most necessary were not the first to go. In addition to the widespread layoffs, many financial institutions streamlined their processes, eliminated business segments not related to their core business, and just generally refocused. The financial industry is leaner and hungrier than it has been in a very long time.

Solid balance sheets
The balance sheets of U.S. financials have been heavily scrutinized by investors, the SEC, the government, hedge funds, and the Federal Reserve. Tier 1 Capital ratios (measures of bank safety) are well above normal. Citigroup, generally considered one of the weakest, has a Tier 1 capital ratio of 11.92% - almost double the level necessary to be called "well-capitalized." In addition, many banks are sitting on extraordinary amounts of cash and have large loan loss reserves.

Financial Reform
The proposed financial reform legislation is often portrayed as a capitalism killer in the conservative media, but it is nothing of the sort. The bill proposes larger capital requirements for those who take more risks, greater transparency in general, and a federal body for winding down companies that nonetheless fail. In other words, large financial institutions will be more subject to scrutiny, require more fallback as their risk levels climbs, and if they fail their operations will be wound down in a manner that is least disruptive to markets and paid for by the industry itself (not taxpayers). Accountability makes for good capitalism.

Valuations
Many financial institutions belong in the single digit forward P/E club. JP Morgan has a forward P/E ratio of 8.2; Goldman Sachs 7.0; Morgan Stanley 7.5, and Citibank 8.9. Citi also has $5.61 of book value per share. Imagine if someone came up to you and said, "I'll sell you this genuine $5 bill for $4 dollars." You would probably assume it was fake, since in the real world this never happens. In the world of Wall Street, however, it happens all the time. At the moment, you can buy $5.61 worth of Citibank assets for $3.81, and get all their clients, brand names, and worldwide businesses for free: Morgan Stanley, Bank of America, MetLife, Travelers, Capital One, and many others are the same.

For small investors to get significant coverage in the financial industry, you need only buy two exchange traded funds - the XLF (large institutions) and the KRE (regional banks). Due to the present worldwide housing bubble, I recommend buying mostly regional banks (KRE) first, until the full brunt of International problems hit their markets (in the short term, psychology trumps value every time). But for value investors, buying time is now.

Statistics (at time of writing):
KRE $27.32
XLF $15.35

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“You can’t make a baby in one month by getting nine women pregnant.”
Warren Buffett, 2009, explaining the importance of investment patience.
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Disclosure and Disclaimer
I own all companies listed here as individual stocks, in ETFs, or both.
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

Is Buy-and-Hold Really Dead?

Since the credit crunch began, many a financial professional has suggested that the buy-and-hold approach to investing is dead. You cannot, they say, simply buy a stock and forget about it. You will lose money.

The most powerful argument against buy-and-hold, popularized during the heat of the crisis, is that if you invested your money in U.S. stocks in 1999 and held them until 2009 (a ten year period), you would have made absolutely nothing: your stocks would not have increased in value at all. Many people found this statement shocking. I also found it shocking, but for a different reason. 1999 was the peak of the Internet bubble. 2009 was dead bottom after the housing bubble. So basically, they were saying that if you were stupid enough to buy stocks at the worst possible time, and then stupid enough to sell those stocks at the worst possible time, you’d still come out even. Truly remarkable.

In reality, buy-and-hold has never meant buying a stock and forgetting about it. Buy-and-hold means buying the stock of a great company at a good price, and holding it for as long as it stays a great company at a good price. If the company's competitiveness declines, sell it. If there are serious “accounting irregularities,” sell it. If the company becomes overvalued, sell it. This is buy-and-hold. So, why does the press always suggest that trading is better? Partially it’s because of ego (surely a complex strategy must be more effective than a simple one); but mostly, it’s because of commissions.

If you buy a stock and sell it several years later you may have a large capital gain, and the government may receive tax income, but Wall Street gains almost nothing. Commissions and trading spreads are the way that Wall Street makes money, and buy-and-hold doesn't encourage either.

You may notice that when you open an account at an online brokerage, they always have free seminars about level II quotes, day trading, chart reading, and anything else that encourages people to trade more. They also have special benefits and pricing for “frequent traders.” In contrast, I have never seen an online brokerage offer a value investing or buy-and-hold seminar, ever. And I probably never will.

Trading certainly has its place, especially in choppy markets. And it’s fun. But for those who can’t marry their computer screens or who do not have a degree in economics, buy-and-hold is the great equalizer. Buying stocks of excellent companies at times of great pessimism, and holding them until times of great enthusiasm, is a moneymaking strategy par excellence.
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“Cash combined with courage in a crisis is priceless.”
Warren Buffett

Power of the VIX

In recent days, newscasters been talking a lot about the VIX – commonly known as the “fear index,” and as an important gauge of investor sentiment.

But, just how well does the VIX measure investor sentiment? More importantly, what relevance does it have to investors? We explore these things and more...

Part 1 - What is the VIX?

The CBOE Volatility Index, or VIX, is a measure of the short-term expected volatility of the S&P 500 stock index. In simple terms, the VIX measures the likelihood that stocks of America’s largest companies will go up and down in value in the near future. The higher the VIX, the more likely it is that stock prices will fluctuate.

Part 2 - Is the VIX a good measure of investor sentiment or fear?

Mostly yes.

Using volatility to measure fear is one of those idiotic things that result when mathematicians attempt to measure human psychology. They do this by creating a model that is relevant most of the time, and assume that it is relevant all of the time.

The VIX makes the grossly inaccurate assumption, common in investing circles, that “volatility” and “risk” are the same. If you ask an average person what they are afraid of, they will not tell you that they are afraid their stocks will go up and down. What they are afraid of is that their stocks will go down and never come back up; that is, they are afraid of a permanent loss of capital.

Having said all that, investors often forget their beliefs and flip out when stocks temporarily drop in value. For practical purposes then, it can be said that while the VIX doesn’t measure what investors are truly afraid of, it does a reasonable job of measuring what they actually react to.

Part 3 - Does the VIX anticipate the future?

While some claim that the VIX anticipates the future, what it actually measures is today’s expectations of the future: so really, it measures the present. Expectations of the future change daily, and so does the VIX.

Part 4 – Is the VIX useful to options and futures users?

If you trade options or futures, it is vital to know the level of the VIX. Options that are far out-of-the-money increase in value only when the underlying stock gets close to the strike price. If volatility is high, the likelihood that your strike price will be reached is also higher. Thus, volatility tends to increase the price of options and futures.

A perfect example of the importance of the VIX occurred last March with UYG (a U.S. financials exchange traded fund), where I made one of the biggest investing mistakes of my life. U.S. financials had just hit a new low and everyone was talking about the end of capitalism, so I knew that financials would soon be going up. To capitalize on this, I bought UYG call options with a strike price of $40, at a time when the price of UYG was $15. And I waited.


Even as UYG climbed from $15 to $35, my call options hardly increased in value at all. The reason? Although the ETF was growing closer and closer to the strike price, the VIX was declining at the same time. My option prices hardly moved, and didn’t substantially increase in value until they hit the strike price. It is an important lesson to all those who would buy options during a time of market turmoil: be aware that during times of large market fluctuations, you will be paying a premium for your options. I would have been better off buying at-the-money options or UYG itself. It was a lost opportunity of regrettable magnitude.

Part 5 - Can the VIX be used to hedge my portfolio?

For those who run their own portfolios like a hedge fund, the VIX is tradable under the symbol “VIX,” and has a negative correlation to equities of about -.80. Reread that last line in case you missed it. VIX or VIX call options can therefore be bought in anticipation of disaster as an excellent hedging tool.

Conclusion

The VIX is vitally important if you buy options or futures, important if you want to hedge your portfolio, and useful if you want to put a number to how much gray hair you just got by watching CNBC. As a measure of investor psychology and market sentiment, however, the VIX has little predictive value: it mostly measures what just happened.
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Note to Journalists reading this blog: Please do me a favor and stop printing the headline, "VIX jumps as stocks fall." The VIX will always jump as stocks fall, since it is part of the calculation. It's like reporting, "Body falls as man jumps out window."
Thank you.