Profiting From the End of the World
George is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
On Thursday, June 20, all hell broke loose. The S&P 500 plummeted 2.5 percent, the NASDAQ declined 2.28 percent, and the Dow Jones Industrial Average fell 2.34 percent, extending the worst two day sell-off this year. Precious metals were crushed as the price of gold fell 7 percent and the price of silver tumbled 9 percent. Other commodities were also hit, with WTI oil prices declining 3 percent and natural gas prices falling 2 percent. Inversely, bond yields also soared, with the 10-year Treasury note climbing to 2.42%, the highest level since August 2011; almost every major bond market across the world was also hit with a yield spike.
Although there were a variety of factors that contributed to the huge sell-off, such as weakening manufacturing growth and credit tightening in China, widespread fears of a slowdown of the Federal Reserve's quantitative easing program provided the main impetus for the market spiral. In his remarks on Wednesday, Federal Reserve Chairman Ben Bernanke stated that if the economy continues to recover, the Federal Reserve would consider slowing down, or "tapering" its purchasing of bonds (quantitative easing) as early as this fall. Moreover, he noted that the Federal Reserve plans to stop buying new bonds when unemployment falls to 7 percent.
Quantitative easing played a large part in the stock market's recent rallies through keeping interest rates low, which in turn encouraged investors to borrow and move into riskier assets such as stocks. Thus, investors are getting jittery about tapering, fearing increasing market volatility and pessimism as a major cushion is being pulled out from under their legs. In the Wednesday conference, many saw their fears of a quantitative easing draw-down substantiated and subsequently started indiscriminately selling as if it were the end of the world.
In such doom and gloom, a key sector stands out as a potential beneficiary of the tapering and eventual end of quantitative easing: banks such as JPMorgan Chase (NYSE: JPM), Citibank (NYSE: C), and Wells Fargo (NYSE: WFC).
Much of a bank's earnings growth is derived from something called net interest margin, which is the difference between how much a bank can charge for loans and how much it gives out for deposits. As noted by Steve Baden, the president of the Royal Banks of Missouri, “the three key measurements [in banking] are net interest margin, efficiency ratio and return on equity — everything else is poppycock.”
This net interest margin has been significantly hit by the Federal Reserve's quantitative easing, which pushes down interest rates and in turn allows banks less room for profit. Net interest margin has been extremely low for the past few years, impacting the entire sector. According to The Wall Street Journal, the average margin for the industry's largest banks in late 2012 was 3.12 percent, the lowest since the second quarter of 2009. Before the Federal Reserve enacted quantitative easing, banks were used to healthy margins of 4 to 5 percent. The net interest margin for all U.S. banks currently stands at 3.21 percent and continues to trend downward:
The mega-banks generally have more diverse revenue streams than regional banks such as Regions Financial (NYSE: RF) and Huntington Bancshares (NASDAQ: HBAN). These two particular banks are especially sensitive to interest rate changes, as noted by a recent Merrill Lynch report. Regional banks often rely on traditional loan deposits for a much greater percentage of their revenues but the tapering of quantitative easing will significantly benefit both regional and national banks.
For example, Citigroup generates around 30% of its revenue from Consumer Banking and Wells Fargo generates 22% of its revenue through Loans. Jamie Dimon of JPMorgan has even stated in his annual letter to shareholders, "As we currently are positioned, if rates went up 300 basis points, our pre-tax profits would increase by approximately $5 billion over a one-year period." Although revenue from the net interest margin doesn't account for a vast majority of the revenue of these big banks, it still matters a lot.
There are many other factors to consider when investing in a bank, but it is definitely smart to be mindful of the potential benefits these banks will reap from current monetary policy changes. As previously stated, regional banks such as Huntington Bancshares and Regions are particularly sensitive to interest rate changes; thus they will have the most upside potential in the event of interest rate increases. Investors with a strong conviction that the Federal Reserve will start tapering soon should look into these stocks. On the other hand, investors that are still uncertain about future Federal Reserve policy should take a look at the mega-banks, which aren't overly dependent on net interest margin but will still profit handsomely from its increase.
Many investors are scared about investing in big banking stocks after the crash, but the sector has one notable stand out. In a sea of mismanaged and dangerous peers, it stands out as The Only Big Bank Built To Last. You can uncover the top pick that Warren Buffett loves in The Motley Fool's new report. It's free, so click here to access it now.
George Liu has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup Inc , Huntington Bancshares, JPMorgan Chase & Co., and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!