Black Swan Alert--Financial Stocks Still Stink

Before anyone gets worked up, the title of this post is meant to be sarcastic, I realize a decline in bank stocks is not a black swan. If anything it is a white swan as I have been saying from the time we knew it was a crisis that there would continue to be shoes to drop for a long time; the worst financial crisis in 80 years will take a while to sort out. Any black swan nazis can instead think of the title as "I want to show you something, it's my shocked face."

Part of the equation for my belief of this taking many years to get healthy again is how long it took the Great Depression to sort itself out. It is probably now generally accepted that the crisis of 2008 did not have anywhere near the societal consequence as the Great Depression but one point just as true but getting less attention is that the crisis of 2008 was/is far more complicated than the Great Depression.

The complexities of the businesses of investment banks and derivatives were/are monumental and I believe the totality of the recent event is far less likely to be fully understood by the people who lived through it than with the Great Depression. If this line of thinking resonates with you then you might agree about it taking years to sort out, correct and fundamentally recover.

I found a very interesting commentary via Barry Ritholtz about how the mentality of picking up nickels in front of steamrollers is alive and well and will destroy Wall Street firms. While it is less clear that Wall Street firms will be destroyed the business with the Whale of JP Morgan losing $2 billion on a hedge creates doubt about what was actually learned from crisis about thinks like risk limits, VaR and other aspects of running a prop desk.

Legislating this would not be the right thing to do for at least two reasons. As a practical matter these institutions always figure out what restrictions will allow them to do an then pile it on. From a philosophical standpoint the only ones that should be protected are the depositors; let equity holders and bond holders eat it if it gets to that point. Having a suitable framework is appropriate but changing that framework in reaction to every big news story that comes along will have very poor results with many unintended outcomes. The financial system is smarter than those who will try to legislate it.

The investment implication here should be to tread very lightly in this sector. We continue to use an individual bank stock from Canada and Chile, the Australian Stock Exchange (ASXFF) and an index provider. The broad sector ETFs are generally heavy in Citigroup (C), Bank of America (BAC) and JP Morgan (JPM) all of which we prefer to avoid. There is a bullish case to be made for JPM that I concede is plausible but we prefer to avoid it. I have been working on finding a couple of very small domestic banks to buy and I think I have found a couple that appear to be very well capitalized, have very good (sustainable) dividends and relatively few moving parts. If I add this type of exposure in I will disclose the name we buy.

One point about the JP Morgan loss to clear up is the notion of losing money on  a hedge. Many have noted that if the hedge failed then the underlying asset must have done well so how could it be a net loss. This is pretty easy to explain with an admittedly simplistic example. Let's say you load up on some stock and you hedge the entire position with puts that are 10% out of the money at a cost of 2% of the long position. The stock then drops 8% and the puts are allowed to expire worthless. Money was lost on the hedge and the position is now down 8%.