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2 Financial Stocks for the Second Quarter

Big banks aren't the best choice. Try Visa and MasterCard instead

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The S&P 500 Index was up 12.59% in the first quarter, with banks coming in as the best-performing sector, up 21.46%. Naturally, the question arises: Should investors chase the Financial Select Sector SPDR (NYSE:XLF) for the rest of the year, given that this great start in 2012 might signal this once-glorious group’s long-awaited comeback? My answer: not aggressively.

When I was asked to contribute a  story on the financials for an InvestorPlace special report reviewing the first quarter and providing outlooks for the second, it was the equivalent of feeding a juicy T-bone to a hungry carnivore. But I prefer taking a top-down perspective because a bottom-up approach to big banks isn’t as productive now given the financial system’s current situation. Enterprising minds might want to click on the links to the relevant monetary indicators in the text.

As a matter of strategy, I believe long-term investors should avoid most large banks in developed markets. Many of these are good “trading” stocks — they go up for a few quarters at a time, and then those rallies tend to unwind. So, you can trade them, but you must be careful not to overstay your welcome. That’s because the record levels of financial system leverage in the developed world hit a wall in the Great Financial Crisis and have been coming down ever since.

In the U.S., total debt as a percentage of GDP as measured by the Federal Reserve Flow of Funds Accounts has slid from 385.7% in the first quarter of 2009 to the present 354.7%.

The financial system is deleveraging despite the Fed’s pregnant balance sheet and Washington’s deficit spending. Aggressive monetary and fiscal measures have not produced any sharp inflation as the M1 money multiplier — a measure of how fractional reserve banking in the U.S. creates systemwide credit — is plunging, as are the velocities of M1 and M2 money supply measures.

Think of this in the following way: Because money turns over more slowly and is being hoarded, you have to increase the quantity of excess reserves and seed credit in the system to keep the total amount of credit — the old M3 measure of money supply that is no longer reported but still can be extrapolated using current Fed data — from going down and creating deflation.

Financial system deleveraging isn’t good for the profits of large U.S. banks because lower levels of leverage can’t support asset prices accustomed to the previous higher level of financial leverage.

A simple recent, unfortunate example that applies here comes from the real estate market. You can buy a bigger more expensive house with zero down payment and an interest only-loan compared to the house you can buy with a 20% down payment and a conventional 30-year mortgage. That is, less leverage, less house.

It’s true that banks are lending to the real economy again as commercial and industrial loans in the U.S. are at $1.37 trillion and growing — a big positive in the current financial system conundrum. But the total amount of such loans outstanding is still way below the $1.6 trillion reached in October 2008.

Don’t get me wrong — there’s norealdeflation in the U.S. at present because this deleveraging shock has been countered by an exceptionally aggressive central bank. As of the time of this writing, bond investors are betting that the Fed will prevail in this monetary battle as 10-Year Treasury InflationIndexed Securities (TIPS) yield a negative 11 basis points! By accepting negative yields on TIPS, investors are betting that the inflation indexing component will rise high enough so that their yields will grow substantially over the next 10 years.

Maybe bond investors will be right in their current TIPS bet because a busted credit intermediation system can be difficult to fix, as the Japanese example of Mitsubishi UFJ Financial Group (NYSE:MTU), Mizuho Financial (NYSE:MFG) and Nomura Holdings (NYSE:NMR) shows. With the risk of oversimplifying the issue, think of those as the Japanese equivalents of JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C) and Morgan Stanley (NYSE:MS), respectively, with the difference that the deleveraging shock in Japan did indeed turn into real deflation there.

Article printed from InvestorPlace Media,

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