Bearish Sentiment vs. Looming Breakout: Banking Risks and the Market's Unyielding Resolve
Abraham George Market Musings
Of late, the markets have been rather dull, trapped in a sideways trading pattern that seems to be dragging on. However, the pressure is steadily building on the upside, as a slew of events and issues continues to captivate our attention. From the banking crisis and the looming debt ceiling issue to the ever-evolving policies of the Federal Reserve, growing tensions with China, talks of de-dollarization, and upcoming G-7 and BRICS meetings, there is no shortage of topics to keep us engaged and excited.
While it's true that most stocks and indexes are currently trading above their 200-day moving averages, there remains a prevailing bearish sentiment among investors. The question lingers: are the investors justified in their skepticism, or is the market poised to prove them wrong? Personally, I side with the market, and my belief is that we are on the verge of a significant upward breakthrough. The more time passes, the more convinced I become that the stock markets will experience a remarkable surge. What fuels this conviction, you might ask? Well, there happens to be an immense amount of cash idling on the sidelines, waiting to be put to work. According to the CFTC's Commitment of Traders report and Bank of America's Asset Manager Survey, the market has been heavily short, or underweight, on equities. As the markets continue their ascent, index-tracking managers will be compelled to purchase stocks, further fueling the upward momentum.
In fact, it's not just the stock market that's showing promise. Other major indices are also breaking out to the upside. German stocks recently reached a 16-month high, with record highs seemingly within reach. Meanwhile, Japanese stocks have been consistently climbing, inching ever closer to levels not seen since July 1990. Truly, there is always a bull market somewhere, if one knows where to look.
Amidst all the financial media's incessant drumming about potential economic downturns, recession signals, risks, and threats, they tend to magnify the negative news while downplaying the positive. However, historical evidence suggests that stock markets have a remarkable track record of surmounting various challenges and climbing a metaphorical "wall of worry." So, my advice is to adopt a "don't worry, be happy" approach and consider taking measured risks in the markets. Rest assured, there are ample opportunities waiting to be seized.
That being said, it would be remiss not to acknowledge the looming risks associated with specific sectors. Allow me to address a few of them, as I understand them.
First and foremost, banks are facing an existential threat. Only those that can anticipate and adapt to the technological and social revolutions challenging conventional banking will be able to weather the storm. To put it simply, banks rely on deposits that can be withdrawn at any time to fund long-term loans, creating a precarious cash flow situation with an inherent imbalance. Should interest rates rise, depositors will demand higher rates on their deposits. If banks fail to meet these demands, depositors will withdraw their funds, as we've witnessed with recent banking failures.
Currently, banks lend approximately $3.25 for every dollar they hold in cash, meaning they can cover withdrawals as long as they remain below a quarter of total deposits. However, if all depositors demand their money back simultaneously, banks will find themselves short on cash. This situation has been a contributing factor to recent failures, marking some of the largest bank collapses in U.S. history.
Before the Great Depression, bank runs were a common occurrence. Rumors of financial troubles would send depositors scrambling to withdraw their cash, fearing the bank would run out of funds, leaving them with nothing. To address this concern, deposit insurance was introduced. For nearly a century, this system functioned reasonably well. However, with advancements in technology, bank runs have taken on a new form. Depositors no longer need to physically line up at the bank; instead, they can simply access their accounts through banking apps, making electronic bank runs a potential vulnerability for most banks.
Thus far, the government has stepped in to protect depositors in the face of recent runs. However, the next wave of failures could prove too substantial for a government bailout. This imminent threat could be triggered by the commercial real estate sector, which finds itself in a dire position, leaving no escape route without a massive wave of loan defaults and subsequent bank runs that would undoubtedly cripple financial institutions.
Renowned investor Charlie Munger, of Berkshire Hathaway fame, has spoken candidly about this issue, which may explain why his company abstained from bidding on First Republic Bank despite JP Morgan securing highly favorable terms. Buffett, known for his shrewd investments during times of crisis and undervalued markets, amassed a staggering $3 billion profit from a $5 billion investment in Goldman Sachs during the 2008 global financial crisis. Furthermore, he doubled his investment in Bank of America in 2011. However, Buffett's recent remarks at the annual Berkshire Hathaway shareholder meeting regarding the recent bank failures indicate a departure from his optimistic stance during the Great Financial Crisis.
"It shouldn't. I don't think it will, but it could, and the incentives in bank regulation are so messed up, and so many people have an interest in having them messed up. It's totally crazy," stated Buffett, highlighting the flawed nature of the current banking regulatory landscape.
In a similar vein, JP Morgan stepped up to acquire a substantial package from First Republic Bank, encompassing $173 billion in loans, $30 billion in securities, and $92 billion in deposits, all for a mere $10.6 billion. Notably, this deal comes with the added benefit of the FDIC covering 80% of JPM's credit losses resulting from bad loans over the first seven years of mortgages and the first five years of commercial loans. While this may seem like a favorable arrangement for JPM, it has repercussions for taxpayers. The FDIC estimates that the cost of cleaning up this mess will amount to approximately $13 billion, a burden that will ultimately fall on the shoulders of taxpayers. Despite having substantial cash reserves, Buffett and his team opted out of this deal.
Adding to the concerns, the Bank Term Funding Program (BTFP) emerged as an ad hoc plan to pacify the markets. Under the terms of this program, it is highly improbable that any bank availing itself of this facility will be able to repay the government within a year. Consequently, the government will likely be compelled to devise yet another plan. Unfortunately, the primary beneficiaries of the BTFP were high-net-worth depositors who had millions at stake. Consequently, an unimaginable moral hazard has been created within the banking system, which is bound to generate legal and regulatory issues in the future.
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Abraham George is a seasoned investment manager with more than 40 years of experience in trading & investment and multi-billion dollar portfolio management spanning diverse environments like banks (HSBC, ADCB), sovereign wealth fund (ADIA), a royal family office, and a hedge fund.