No one who owns bank stocks is complaining, as the unexpected outcome of the presidential election caused shares of the nation's leading lenders to surge by double-digit percentages. The issue now, however, is that valuations in the industry have diverged from the fundamentals. What's driving bank stocks currently is speculation about whether the Trump administration will be able to deregulate the financial services industry and thereby boost profits at large banks.
In the following segment of Industry Focus: Financials, The Motley Fool's Gaby Lapera and John Maxfield discuss why this is such treacherous territory for investors in bank stocks.
A full transcript follows the video.
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This video was recorded on April 17, 2017.
Gaby Lapera: If you've been following the banking sector for at least the last four or five months, you might have noticed that there was something that is now affectionately called the Trump bump, which was right after the election, bank stocks took off. And that's not a coincidence, because one of the things that Trump talked about on the campaign trail over and over again was deregulation and allowing more freedom for the banks. And people drove bank stocks up on the assumption that this regulation was, especially Dodd-Frank, that's really what we're talking about when we say regulation, that that was going to be repealed or changed in such a way that banks would have more freedom, and they were going to be able to drive up their profits.
John Maxfield: Yeah. So, what we saw in the election is, bank stocks went up 20%-30% almost immediately. The election happened in November, earnings didn't come out until the middle or beginning of October, and then the Federal Reserve raised rates in December, and then earnings for the fourth quarter didn't come out until January. So there were no fundamental catalysts -- and when I say fundamental catalysts, I mean there was nothing company-specific. It's not like a company came out and said, "We quadrupled our earnings on a year-over-year basis," and everybody thought, "Oh, all banks are going to quadruple their earnings on a year-over-year basis." It was that you had this expectation fueled rally in bank stocks around this idea that if Donald Trump's team at the White House is able to get through easing of the regulations in the banking industry, that that is going to cause profits to go way up.
It's hard to see right now how profits at these banks that are earning more money than they've ever end before. Even Bank of America -- which has dug itself out of the financial crisis but is still deep in the throes of seeing its profitability recover -- even it has shot way up. So the question is, what does that mean for investors? And what it means to me is that you have to be really careful in this zone right now, because I don't think we can expect a 25% boost in profit at these big banks that are earning so much money. And JPMorgan Chase is earning more than it's ever earned on a quarterly basis. It's just hard to understand how, even if there are significant deregulatory moves made in this area, that it's going to have such a huge impact on profits.
Lapera: Yeah. So basically, the stock-price increase is a gamble by investors thinking that these banks will make way more money than they're already making. And as you pointed out, Maxfield, the banks are already making quite a bit of money. So I'm not 100% sure how they would make even more money just like that as soon as deregulation happens. The other thing to think about is, I think there's a post-election high where everyone was like, "Yeah, he's going to get in there, the first 100 days he's going to get a lot pushed through," and the reality is, in Washington D.C., nothing happens quickly. And that's for a reason; that's a protective thing that D.C. has. I know people hate to hear that, but it's good that people can't make rash decisions and changes to legislation, whether or not they're good. This way, it gives everyone a lot of time to consider what the ramifications of any given legislation will be. But that also means that legislation takes a really long time to push through. And banking regulation, as dry and complex as it is, is probably going to take even longer than other types of regulation.
Maxfield: And we saw, with the challenges, trying to get that initial healthcare bill through, that just because there's unity between the branches, Republican-controlled White House, House, and Senate, there are still factions in there that are going to make the legislative agenda difficult to get through. Here is where it gets really dicey for investors. Because bank stocks are up on an expectations-infused rally, it means that investors are thinking and making decisions in the political context. One of the things we know, when a person makes decisions in the political context, is that it is extremely difficult, regardless of which side of the aisle you're on, to make objective, fact-based decisions.
In fact, there's this great book, Mistakes Were Made (but Not by Me), that digs into a particular type of behavioral bias known as cognitive dissonance. One of the things that they talk about in that book is, there was a study done where people, Democrats and Republicans, were put into MRIs, and then confronted with information that was either consistent or inconsistent with their political beliefs. And what they saw was, when information that was consistent with your political belief was introduced and you started thinking about it, the area of your brain that is responsible for making deep, analytical insights started firing. But what happened was, if information that you disagreed with politically was introduced, that same area of the brain, they saw, actually shut down. So, what that means is, the way our brain works, when there is information in the political context that we agree with, we incorporate that into our analysis, but the information that we disagree with, we do not incorporate that into our analysis. And in the investing world, which is really unforgiving because you're talking about numbers and money, you need both sides of the story to have a balanced approach.
Lapera: Yeah. And I think I actually see where you're going with this. There was a story out of Wisconsin. I will quote to you part of it. "When GOP voters in Wisconsin were asked last October whether the economy had gotten better or worse over the past year, they said worse, by a margin of 28 points. But when they were asked the very same question last month," in March, "they said better, by a margin of 54 points." That's a net swing of 82% between late October 2016 and mid-March 2017. That's crazy, because there's no way the economy has changed that much between October and March. So it really just comes down to people's perceptions of how the economy is doing. And even more than that, when you ask Democrats that same question, it was basically flipped. Democrats were saying, "We think the economy is way worse; we think a recession is imminent." So this is something that I don't know it's ever been seen before, but we're really letting political activity cloud how we're viewing the economy, which fundamentally can alter how you view investing decisions.
Maxfield: Right, and the Michigan consumer-confidence survey, which is an even broader survey than the Wisconsin survey, it confirmed the same thing. It found a stark partisan divide between how Democrats view the economy and how Republicans view the economy. In fact, I can't remember if it was January or February when it was the largest partisan divide that survey had ever seen, but I think it narrowed a bit in a more recent month, but it's still relatively wide. To your point, what they have seen is, since Donald Trump has taken office, optimism among Republicans has shot way, way up, but among Democrats it has shot way down. So Democrats are expecting, generally, an imminent recession. The data shows they're expecting a recession. The Republicans are expecting a robust recovery. This just goes to the point. I think there's two points here. First, consumer-confidence data is more complicated than the headline number. Second, this goes to the point that when you're in the political realm, even when you're making decisions about things that are non-political, i.e., the economy or investing, politics still creeps in and short-circuits a rational, objective, fact based thought process.
Lapera: Yeah. I mean, honestly, the truth is probably somewhere in between, because that's generally how it goes with these things. But I think the message we're trying to deliver to you, dear listeners, is that you should do your best to make decisions about companies based on the company's fundamentals. Ignore the outside noise. Don't let it creep in. Focus on what you think is good for a company. Don't make bets on what you think other people are going to do. That's how you evaluate a company. That's how you become a long-term thinker and a long-term investor.