"The money-changers have fled from their high seats in the temple of our civilization. We may now restore that temple to the ancient truths." -- Franklin D. Roosevelt
It may be an overly dramatic title for our perspective on financial stocks. But as with Francis Fukayama's famous essay on the "End of History," we really don't mean the end, rather perhaps the end of a struggle. Of course, history certainly didn't end, and neither will the financial sector. However, it is still true that the financial sector has won the secular tussle between the world's "industrial and financial circulations" for money and profits. Starting from small beginnings, the moneychangers today represent the largest equity component of corporate values around the globe and also by far the largest profit share. Is the end of financial evolution then near, or is there more history yet to be written? On that question, we think at least one more secular down cycle for the financial sector will be part of that history sometime soon. But when, exactly? It's a hazardous question; Roosevelt was early in his prediction by at least 60 years.
It may seem a little churlish to explore the idea of underweighting or shorting the financial sector in investment portfolios at this time. After all, financial service stocks in North America have been on an upward tear for years ... in fact, for around two decades or so. Viewing asset quality indicators, analysts may be quick to argue our line of inquiry. After all, actual and expected company defaults, credit downgrades and various quality yield-spreads are at their lowest levels around the globe in a decade. Closer to home, monetary interest rate payments as a percentage of US national disposable income, some argue, is still manageable, though not much lower than experienced in the early 1980s when interest rates were three times today's levels. While we want to be careful not to step in front of a financial bulldozer before it runs out of fuel, it's worth pointing out that these conditions do not necessarily mean that all is well. There are a lot of qualitative factors that must be considered, as well.
Key to recognize is that mounting non-productive debt relative to income, gross mis-pricing of risk and rising interest rates are the main factors that have played a role in every ensuing financial crisis or downturn of past history. Critically, all of these factors are now in play. Credit is easy, debt is booming, lending standards are near rock bottom, investors are reaching for higher yield regardless of quality and risk, and interest rates are clearly rising in North America. Given all that, it's not untimely to at least think about underweighting financial stocks. We wouldn't be the first ones in any case. Interestingly, insider selling in financials has soared recently.
Financials - The Secular Era
The financial sector - whatever the subspecializations - has enjoyed the wind at its back for a long time. Whenever the history books are written on this post-Bretton Woods era, its attendant "financialization" and "money mobility" booms will be among the central themes of the story. But just what do we mean by "financialization"? It embraces the concept of how forms of money and financial instruments capture and capitalize human activities and services - from pension funds, to risk transfer to consumption and other "open market" transactions. We won't spend the time to document this trend, nor the unparalleled boom in financial assets and liabilities that have been the latest outgrowth of this unprecedented phase of modern human financial history. We'll just briefly mention the main pistons of the financialization engine. In its simplest form, there are five main drivers: 1. Volume of Consumption and Human Activity 2. Volume of Interpersonal Trade 3. Money Share of Transactional Trade 4. Capitalization of Money Flows (a catch-all embracing quite a number of dynamics), and 5. Valuation (Eye of the Beholder).
All together, advancing in fits and spats, it is a process that has been observable for well over a century. By some estimates, the "nexus" of money and finance has increased its market share of human activity by a factor of four, to as much as 80% over this time span. The net result, depending on the calculation, is that "financialized" wealth accounts for anywhere between 5X and 10X the size of the world's annual economic output. As the popular Saturday Night Live character used to say "baseball been bery, bery good" to the financial business during the most recent leg of this boom.
Figures #1 and #2 give an indication of the impact of the "financialization" phenomenon on the financial services sector in the US over the past 50 years or so. We say only an "indication," as the available data actually underestimates this trend. Financial services are often wrapped up with other services and therefore may not be identified as a "financial industry" activity in the national accounts data. According to the estimates of the Federal Reserve Board, the equity market value of financial corporate equity today makes up an all-time high of 27% (1st quarter 2005) of total corporate equity. Notably, this share of equity value increased by 50% since early 2000 - a short period of only 5 years.
Seen over the period since 1981/82, when the financial service sector was beginning to recover from the previous recession, S&L troubles, and a negative yield/curve environment, the relative share of financial equities has more than tripled from a low of only 8.8%. Assuredly a number of other factors contributed to this ascendancy, including the demise of the technology bubble post-2000 and the steady implosion of the manufacturing sector. All the same, seen in retrospect, it has been almost a one-way ride for financial services. But, is it realistic to expect that the financial sector can account for an even greater portion of the North American economy and equity market? It doesn't seem plausible, but it is true that it already accounts for an even bigger share of profits.
Compound Earnings at Work
According to US national accounts data, financial services today account for greater than 35% of domestic corporate earnings. Before a general corporate earnings rebound began in 2002, this share even reached 45.3% (see Figure #2) during the 4th quarter of 2001. Some analysts, who also estimate the financial service revenues not captured by the industry code categories of the government's data-gatherers, suggest that financial service earnings may even exceed 50% of domestic corporate earnings today. Again, returning to government data (NIPA), financial earnings today are also at a record high of 3.3% of national income, almost 9 times higher than the share for the 1982 year. (See Figure #3) That extent of resource reallocation to financial services within the economy is of course driven by stellar profit growth opportunities. Sure enough, the average annual profit growth of the financial sector over the past 20 years has logged in at approximately 20%, 4 times higher than all other domestic corporate earnings.
A second major cause of this relative shift of earnings (though also related) is the demise of US manufacturing. The relative profit trends between the financial and non-financial sectors of the US economy (also shown in Figure #2) couldn't have been more divergent over the past two decades. It represents the direct fall-out of a shift to consumption (vs. investment) and overly-generous credit supply over this period.
The reason that this huge earnings growth has not translated into a higher stock market valuation for the financial sector (large as it already is) we think is a function of two main developments. For one, lately, natural resource sectors have come back in favor. A second dynamic that is happening is that investors have been reluctant to value the apparently superlative earnings of the overall financial industry as highly as before. This is logical, because as mentioned, it is highly unlikely that the financial service sector of the world's largest economy can continue growing and profiting at rates of the recent past. After all, if this would be the case, eventually US economic activity would be comprised totally of borrowers and lenders ... i.e. the moneychangers would have all the high seats in the temple.
A Nation of Lenders, Borrowers & Moneychangers
If one were to extrapolate the recent growth of financial earnings vis-à-vis its share growth of total national income, in 25 years greater than 30% of net national income would be captured by the profits of this sector. That won't happen because it is simply impossible. Financial services by their very nature need to remain symbiotically parasitic (though not all of them are!). They basically can only continue thriving so long as they don't kill their host client. All in all, it's a delicate relationship similar to the fermentation process in a wine vat. After sufficient sugar is converted by the yeast to alcohol, proof levels become toxic and kill off the same yeast. Of course, if financial executives had their druthers, they will prefer even higher financial profits (i.e. higher alcohol content) but too much will kill the host. If so, are there any signs that the golden goose is showing signs of wooziness?
The Happy Side and the Flip Side
While investors and asset managers all like to celebrate the growth in the value of financial assets and financial service stocks overall, an eye must be kept on the other side of the balance sheet of the financial sector, especially so if asset growth continues much faster than underlying income growth. As debt levels rise relative to underlying income, whether at the personal, household or at a national level, the wealth skew must continue to widen. But back to real estate. Though many homeowners and investors may be enthused about rising real estate prices, if much of this rise in values is being financed by new debt (as it is), toxic vulnerabilities also open up. As the saying goes, "for every borrower, a lender must be." Higher overall debt level relative to underlying income levels also must mean that a lender is agreeing to lend on less favorable quality terms. Figure #5 shows the flip side of higher mortgage indebtedness from the perspective of the commercial banking industry. As real estate related financing has soared, so has the exposure of these banks to real estate. Mortgage related assets (including the securities of the government-sponsored entities, or GSEs) now account for 44% of the assets of commercial banks, an all-time high by a substantial length. Should real estate conditions ever turn negative (as they surely will at some point, perhaps due to rising interest rates) there exists greater vulnerability for banks and the financial sector than ever before.
Overall, US corporate earnings and equity market trends have been highly impacted by the boom of the financial sector. Analysts who believe that a financial bubble currently exists, will agree that this is an ineluctable side effect ... in fact, a very symptom that helps in identifying the existence of a financial bubble. Were financial earnings ever to return to a more normal 1% of national income (which would be close to the 50 year average) that would translate into a 25-30% decline in overall corporate earnings (everything else being equal). This is not an overly pessimistic scenario. We are only talking about normalized levels, not the possibility of a hard cyclical downturn that could involve significant net losses. Whatever the case, it is one reason why we consider the current P/E multiple of most North American equity markets are still deceptively expensive. Adjusting for the non-sustainable impact of a financial bubble upon overall corporate earnings, a 20X multiple on today's profit levels really should be seen as a valuation level closer to 25X - 30X earnings. That's expensive.
In the meantime, the rate of wealth transfer between the "haves" and "have nots" continues. Wealth distribution in the US continues to skew to extremes not recorded since the days of the robber barons at the turn of the last century. As pointed out, the potentiality for serious strains between the borrowers, lenders and users of other financial services and instruments has stealthily continued to grow under the cover of declining interest rates. The turn-over of monetary interest payments - the "cash" money flowing between lenders and borrowers for payment of interest - remains inordinately high for the US household sector even as interest rates have declined to all time lows. (See Figure #4) But now, low interest rates are history.
Conclusions: No Harm Underweighting Financials Rising interest rates as well as complicating factors surrounding a renewed slump in the US dollar (a central expectation of ours) will bite into the disposable income of borrowers as well as frustrate profits in the financial sector.
We see no shortage of factors suggesting reason for caution with respect to the financial service sector overall. Taking a longer-term view, an underweight appears compelling. Short-term timing seems favorable, too. In our view, given rising interest rates, a flattening yield curve , higher credit risk, deteriorating quality of the assets and steepening debt relative to underlying income, an underweight could begin to payoff at any time. A resumption in the decline of the dollar could also act to puncture the bubble of the "money changers." In our view, a sizable underweight in the financial service sector overall likely carries little performance risk from this point forward.
For a start, we conclude that the epic "financialization" boom is certainly vulnerable to a slowdown. We can always worry about the end later.