The Downside of Bank Stocks
Since bank stocks are so closely tied to economic performance, the performance of their stock price is very cyclical, moving with the current economic conditions. During expansionary phases they do very well, better than most, but during economic contraction they get hit harder than most and tend to take longer to bounce back.
Down cycles are exactly what you don’t want to see if you are a bank, with your ability to borrow reduced as well as your ability to lend. Leaner times mean that there is less money around to put in a bank, and less business growth as well meaning demand for borrowing and many other of their services is reduced, and this of course will impact profits.
Banks are also exposed to the market to a larger degree than just about any other business, and they are in on the long side pretty much, so bear markets are going to take a bite out of not only the bank’s stock due to less demand, it may also affect some of its holdings, meaning that their profit is also affected.
Leaner times mean higher default rates as well and this is one of the biggest things that happen during economic downturns, as the ability for people and businesses to continue to make timely loan payments is reduced. This might have been all running smoothly when times were good but when things sour, things can really sour.
Banks hold most of their assets in income streams from loan repayments, so if this stream is reduced, this can have a big impact upon a bank’s bottom line.
Banks Also Compete Among Themselves
The banking sector may be doing fine at some point in time, but this doesn’t’ mean that all banks are. Banking is a very competitive business overall and especially in over saturated markets like the United States. Even in countries like Canada where 5 just banks do almost all the business, these banks compete fiercely with each other and some stocks are simply better than others as these businesses perform at different rates.
Even though banks are conservative by nature, the perception of the degree of conservatism present tends to be overestimated by the public, and not entirely by accident either as banks work hard on creating and cultivating these images and beliefs.
Some banks are more daring than others and therefore risk appetites differ. We have and need regulation to keep banks from getting too bold actually and leveraging themselves too much, and you only have to look at the mortgage backed securities fiasco to get a taste of how risky banks can be if you let them.
Investment banks of course tend to have a bigger risk appetite than retail banks do, due to the nature of investments over relying more on things like loans, with investments at least having the potential to be more risky, depending on the strategy.
Competition does drive banks to become more risk seeking though, in an effort to outperform one another, either in the investment arena or with taking on more loans or loans that may be riskier. Shareholders also put pressure on them here, to outdo one another with dividends for instance, and this is going to present itself with varying degrees of sustainability.
Banks also need to attract the best talent and this can involve basing people’s compensation more on short term results than may be healthy for the bank, which can end up adding risk, especially if this causes everyone to focus on the next fiscal year rather then on the longer run, getting away from the critical balance that must be sought between these timeframes when running a corporation.
Timing Is Everything
Since bank stocks are so market sensitive, there is perhaps no other type of stock that benefits from proper timing. Since equities trading is so momentum based, economic variables do get priced in as they change, but the response to them tends to vary a lot, as is the case with stock prices in general.
If one is looking to use a buy and hold strategy with bank stocks, which many people do, there is something to be said about the dividends offsetting downward price movements at least somewhat, and when bank stocks are depressed due to market forces, provided that the bank’s profitability is sustained, investors may not even care much about where the stock is moving to.
This is probably the case more with bank stocks than any other types of stocks actually. The potential problem with this is that one can become too exposed to sector risk if one’s bank stock holdings represent too big a chunk of one’s portfolio, not diversified enough in other words.
These are real concerns, and many would call just going with bank stocks in one’s portfolio an unsound and excessively risky strategy. This does not mean one does not want to do it though, as this is only unsound and too risky if one plans on holding the stocks past the point where it makes sense to.
Stock holding always involves timing, and there’s two types, the timing of not being exposed during the time that one plans on selling, and the timing of the stocks in general, where one is looking to enter and exit at strategic times.
In spite of the feeling of a lot of people that you can’t really time anything, which is nonsense actually, many individual investors have a lot of success doing so, and it’s really not even that hard to do. You don’t have to be an expert with the latest software and methods of analysis to do this ln an individual level, although this becomes much, much more difficult when managing funds with billions of dollars in play.
Timing markets does take some skill though, and more than a lot of people realize, but this is still within reach of a lot of individual investors should they be willing to put the effort in and have at least a decent aptitude for learning, in addition to enough self confidence and discipline.
It’s All About Your Strategy
It is true that going heavier on bank stocks in a buy and hold portfolio is probably not a great idea, even though some individual investors really like this and will point out periods of time where the banking sector has outperformed the broader market over a fairly long period of time.
The problem is that bank stocks tend to more volatile than most, which is a trader’s dream but can be an investor’s nightmare if one either is looking to sell prior to the recovery or wasn’t planning on doing so but ends up selling due to a lack of resolve or excessive fear.
We don’t want to overrate stock market diversification too much either though, as market risk tends to involve most stocks, meaning that during a downturn most boats sink together due to the receding level of the ocean so to speak. Some sectors are riskier than others though and bank stocks are in this category so it’s not that extra caution isn’t needed, but we don’t want to allow ourselves to be lulled into a false sense of security with sector diversity either.
Others may simply look to enter and exit at appropriate times, abandoning ship when it makes sense to do so, which isn’t after the tidal wave has mostly hit by the way. The key to timing markets is to be surer and quicker than most, because when most have acted it’s usually too late and far too late even.
So bank stocks can be very appealing in the good times and fairly easy to predict as well during the bad times when you want to be mostly out of them, and in the mean time when we’re holding them, the above average dividends are a nice bonus as well. Some investors don’t belong in bank stocks at all perhaps, but some just may be able to leverage the added potential that they have.