Investors should be wary of the stock market right now, given the low volatility and high valuations. If you're thinking about buying bank stocks in this environment, it would be smart to stick with the best -- U.S. Bancorp (USB -1.58%), JPMorgan Chase (JPM -1.42%), and M&T Bank (MTB -3.14%).
Investors are worried about the market
If you read what the country's most revered investors and financiers have been saying this year, you can discern a general theme: They're worried about the market, especially the combination of low volatility and high asset valuations.
In terms of valuation, stocks have been higher only twice before, based on the Case Shiller cyclically adjusted price-to-earnings ratio. The first time was in 1929. The second was 1999. Neither ended well.
Data source: Robert Shiller. Chart by author.
And in terms of volatility, Ray Dalio, the chairman and chief investment officer of Bridgewater Associates, the world's largest hedge fund, included the chart below in a recent LinkedIn post:
Data source: Ray Dalio.
As you can see, each time volatility bottomed out, it tended to then increase sharply. This was apparent in the lead-up to the stock market crash in 1929, as well as the housing bubble preceding the financial crisis of 2008.
Historical analogies for today's stock market
The similarities between those two events seem to inform Dalio's thoughts on the economy and markets today, which he finds reminiscent of 1937.
You can see the significance of this timing in the chart below, which shows the S&P 500 from the years 1900-1950. The most prominent spike was around the Crash of 1929. Then, eight years later, a second spike occurred in 1937.
Data source: Robert Shiller. Chart by author.
There are other similarities between the two time periods. Probably the most important one is income inequality, which was high in the 1920s before dropping off after the New Deal and World War II.
But inequality began climbing again in the 1970s. Today, the top 10% of income earners in the United States account for more than 50% of total income earned in the country. It's the first time that has happened in over a century -- and probably longer, but I couldn't get data further back.
Data source: World Wealth and Income Database. Chart by author.
There are two overarching reasons that inequality is bad for an economy. The first is that it leads to lower growth, as people with higher incomes tend to save a larger share of their income compared to people with lower incomes. As a result, progressively less money that is spent in the economy makes its way back into it to serve as fuel for further growth.
Additionally, with income inequality comes populist politics -- another trend the United States is experiencing now, as it did between World Wars I and II. If you read between the lines of what investors like Dalio are saying, in fact, you'd be excused for inferring that politics could be the catalyst for a correction in asset prices.
Here's Dalio:
Ordinarily, politics and economics influence each other, with economics being more of a driver on politics than politics is on economics -- e.g., bad economic conditions normally lead to political changes -- and normally we don't need to pay much attention to politics to get the economics and markets right. However, there are times when politics becomes the most important driver. History has shown us that these times are when there is great economic, social, and political polarity within a country, and there is the selection of populist leaders to fight for "the common man" in a battle against "the elites." These conditions exist now. The 1930s were the last time this happened in the developed world and globally.
Possible stock market catalysts
The most likely near-term catalyst is tax reform. The Senate is currently working through its bill, but there remain a number of holdouts that could prevent it from becoming law. It would be bad for stocks if the bill didn't pass because the 22% climb in the S&P 500 since the presidential election last year must have been, at least in part, powered by hopes of a lower corporate tax rate, as Donald Trump vowed on the campaign trail to cut the corporate tax rate from 35% to 15%.
Aside from tax reform, another possible catalyst could materialize if the Special Counsel's investigation were to uncover dispositive evidence of a more troubling connection between the White House and Russia. An admittedly rough historical parallel for this, albeit a loose one, is the early 1960s. Following an extended period of growth, stocks dropped more than 20% from December 1961 to June 1962 in what came to be known as the Kennedy Slide of 1962. Stocks didn't fully recover until after the Cuban Missile Crisis.
Image source: Getty Images.
3 safe bank stocks
Regardless of the catalyst, it seems prudent for investors to start thinking more defensively about the stocks they are buying. "This is not the time period where you say, 'I can buy anything and not worry about the risk of it,'" said Jeffrey Gundlach, co-founder and CEO of DoubleLine Capital, earlier this year.
With this in mind, it's no coincidence that all three of the banks I mentioned above proved through the financial crisis that they perform at a high level in all stages of the business cycle:
- Money flooded into U.S. Bancorp during the crisis, as the bank emerged with the highest debt rating in the industry. It went on to be the most profitable big bank in the United States for seven consecutive years, a streak that is still ongoing.
- JPMorgan Chase made two major acquisitions for pennies on the dollar, buying Bear Stearns in March 2008 and Washington Mutual six months later. As a result, while JPMorgan Chase entered the crisis as the nation's third biggest bank, it emerged as the biggest, passing Citigroup (C -2.73%) and Bank of America (BAC -4.20%) along the way.
- And M&T Bank continued its tradition of growing through acquisitions on the back end of crises. The returns generated by this strategy make the bank's CEO the bank industry's equivalent of Warren Buffett, whose holding company, Berkshire Hathaway, is not coincidentally a major investor in M&T Bank.
None of this is to say that Bank of America and Citigroup are not good buys either, especially given their comparatively reasonable valuations. But if I had to go with a bank stock right now, it would be one that leaves no doubt about its ability to thrive through the next correction or recession.
