In June last year we issued our alert on Australian banking.
This was a bearish alert on the Australian banking sector, which was really a proxy for trading our bearish view on what can only be described as a batshit crazy real estate market aka the Australian property market.
We applied the view with a long short trade: long the iShares S&P Global Financials Sector Index Fund (IXG) and short Westpac bank ADR (WBK).
We really like this trade and we expect to continue to make money over the coming months. However, we believe we can improve on the trade by being more specific by not taking any overweight exposure to the US and eliminating exposure to the insurance sector (IXG has a 50% weighting to the US and 25% exposure to the insurance sector).
And as such, we are closing out our IXG/WBK trade and constructing a more comprehensive set of trades the combination of which we believe does two things:
One, they decrease our overall sector risk, and two, they do so without changing the upside potential inherent in the overall sector allocation.
This is what we’re doing.
Long the following:
- Bank of America (NYSE: BAC)
- DBS Group Holdings (SGX: D05)
- Sumitomo Mitsui Financial Group (NYSE: SMFG or TYO: 8316)
Short the following:
- Westpac (NYSE: WBK or ASX: WBC). We are already short this so there is no need to change this position. All that requires doing is pairing it with one of the above long legs.
- Commonwealth Bank of Australia (ASX: CBA)
- National Australia Bank (ASX: NAB)
Australian Banks: At a Tipping Point
We’re writing again to detail this trade because, quite frankly, we feel we really are at a tipping point and we are staring down the face of a trade (or at least theme) with huge upside.
So what has happened in the last 12 months since we issued the trade alert?
I want to spend more time on discussing ways of applying the bearish view on Australian banks. So I’m going to go a bit light on the discussion around the view. It’s not because I’m lazy but rather I don’t want to reinvent the wheel, and we’ve covered this ground in our initial alert.
Over the last 12 months there has been some interesting discussions and research published. I cannot add any value to the view given what is discussed in the following. Where I think I can add value is in the way to apply the view (but more on that later).
Probably all you need to know about the Australian banking bubble is covered in a Real Vision interview with William Strong:
Mr. Steve Keen – no holds barred and “controversial”. Take it away:
And Martin North with a well-reasoned methodical analysis of the Australian real estate market and everything that goes with it:
And here is something a little more dramatic and way scarier to watch (scary if you are heavily invested in the Australian and New Zealand property markets):
It intrigues me that already about 25% of Australian households with a mortgage are in debt distress. That is nuts!
And so we ask ourselves the question, what happens if rates were to rise? Because remember, all of this is taking place while we’re enjoying THE lowest interest rates ever. The article below notes that with just a 50bpt rise in rates debt distress goes from 1 in 4 to 1 in 3 households.
If we are to allow ourselves the pleasure of indulging in the simple math of what happens to these same distress levels should mortgage rates merely “normalize” and get back to pre-GFC levels, we’re left – once we’ve picked our jaw up off the floor and cleaned the coffee we just spat all over the keyboard – conceding it’s hard to NOT be involved in this trade in some fashion.
Recall that these record levels of debt coincided with rates going from low to lower. The two are naturally related. And this is reversing now. Granted the RBA isn’t raising rates, but up to 40% of Australian banks’ funding comes from the wholesale market, and those rates have been rising.
Here’s LIBOR for 3, 6, and 12-month rates:
None of this points towards what the market still stubbornly expects. Namely, “lower for longer”.
Granted the average Joe Sixpack knows about LIBOR in the same way I know about Justin Bieber. And this is where the propensity for Joe to have a once in a lifetime car crash is highest. We know this because “Joe” just keeps at it. Borrowing, that is.
I could go on and provide more data, but I don’t want to bore you on the topic. Rather let’s focus on what to do about it all.
The question isn’t bearish or bullish but rather how bearish and how to construct sensible high reward trades while minimising our risk of losses.
Certainly, the downside in Australian real estate is significant. Arguably far more significant than that experienced by US investors in the ‘08 crisis. The reason I say that is because going into the ‘08 crisis central banks’ rates were:
- Not at zero, and
- Global central bank coordination was pulled of remarkably quickly. This time that’s just not in the cards (a topic I’ve covered in the past and how the geopolitical world has changed substantially since the last crisis).
In any event, the boom in Australian and New Zealand property markets (particularly in the big cities) has gone on way longer than just the last 7 years or so. It stretches back to the late 1990s.
What we’re looking at here is the Dow Jones Titans Bank Index (top 30 banking stocks in the world) relative to CBA (using CBA as a proxy for the Australian banking sector). Underperformance from 1994 to 2014 – 20 years.
If you believe in “mean reversion”, then this chart tells us that Australian banks are going to underperform world banks for a very long time (way more than 10 years), and the magnitude of the underperformance is likely to be huge (i.e. the big risk to the “bearish Australian banks” trade is getting off this bandwagon to early).
When I first started to entertain the idea of getting bearish Australian banks, CBA was the 7th biggest bank in the world by market cap. And if you added up the market cap of all the Australian banks, they accounted for some 11% of the capitalization of the top 100 banks in the world.
So how does that work? Australian and New Zealand, with a tiny 30 million people and its banking assets accounting for about 10% of the capitalization of the world banking sector? That’s not right no matter what justifications apologist economists in both countries come up with.
SMSF Investing: A Ticking Time Bomb
In our alert from June last year we overlooked the impact of Self-Managed Super Funds (SMSFs) leveraging up to buy property. These are the equivalent of self-directed IRAs for our US investors.
Some 15 years ago the Australian government allowed Self-Managed Super Funds (SMSFs) to leverage into property and other investments. This unwittingly allowed SMSFs to be turned into speculative vehicles rather than savings vehicles.
This dramatically increased the riskiness of Australia’s retirement savings and financial system and further inflated Australian house prices. In discussions with some friends of mine who manage money in the “lucky country” it became evident to me that SMSFs are invested not only in real estate directly, but take a guess what forms the bases of their dividend paying “diversification” in their portfolios? You guessed it, the Australian banks.
I found this article, which further validated conversations I had.
The more I research the Australian property market the more I get the feeling that Australian society has become geared to and extremely dependent on property prices. As with everything that is done with excess for extended periods of time, very strange things start coming out of the woodwork when this unwinds.
Applying the View
The trade in our Australian bank alert last year was long the iShares S&P Global Financials Sector Index Fund (IXG) and short Westpac bank ADR (WBK).
This was an effective and straightforward method to go long world banks, and it has worked quite well for us. Pairing trades is important in this instance since the costs to shorting what are high dividend paying equities sucks too much juice out of the trade and exposes us to unwanted time horizons. What we’re wanting to do is to put on asymmetric trades where our risks are limited, and we can weather storms along the way until our ship comes in to port.
However, as mentioned earlier, in the long-term I think we can do better than just buying long the iShares S&P Global Financials Sector Index Fund (IXG).
Below is the breakdown of IXG:
Here is the essence of the exposure:
- 47% to the US, so about half of the exposure is to the US.
- 26% to insurance. I don’t want this exposure as I want just banking exposure.
US banks have outperformed other world banks and insurance has outperformed banks. So I’m certainly not complaining about this trade over the last 12 months or so. And yes, this trade will continue to do well. We certainly haven’t changed our long-term view about it and for those of you who already have the trade on and frankly can’t be bothered changing it, we don’t have a problem with that.
However, we do think we can improve on this trade by reducing its volatility and improving its ultimate upside.
Our idea is to “re-engineer” the trade so that we only have exposure to banking stocks and not to concentrate our long in favour the US market. On the other hand, we do want to eliminate any exposure to Canadian and European banks. Canada finds itself in a situation similar to the Australia and we have strong doubts as to whether European banks will outperform US and Japanese banks. Europe is, for lack of a better word, a mess.
Here is Our Amended Idea
Go long US, Asian, and Japanese banks against Australian banks. Specifically:
Long the following:
- Bank of America (NYSE: BAC)
- DBS Group Holdings (SGX: D05)
- Sumitomo Mitsui Financial Group (NYSE: SMFG or TYO: 8316
We chose each of these banks since they provide a good representation of the banking sector of each of their respective geographical regions.
We could argue over whether or not to choose JPM or Citi over BAC, Mitsubishi over Sumitomo, or UOB over DBS… or just to buy an ETF (like KBE or 1615). But I think the argument is somewhat moot. Rather the question is how aggressive to get on the trade? In other words, what percentage of one’s portfolio should be placed on these trades?
We would be happy having at least a 3% exposure but we fear that this will ultimately prove to be way too conservative.
Note this isn’t necessarily a recommendation. A full position for me is 5%, but many folks far smarter than me don’t do this. Each to his own and you can, and should, position size in a fashion that makes the most sense to you.
Here is our short list:
Short the following:
- Westpac (NYSE: WBK or ASX: WBC). We are already short this so there is no change.
- Commonwealth Bank of Australia (ASX: CBA)
- National Australia Bank (ASX: NAB)
The trade should be done in equal dollar amounts. For example, if we are long US$5,000 in each of BAC, DBS, and Sumitomo Bank, then you would need to be short US$5,000 in each of WBK/WBC, CBA, and NAB. Rebalancing should be done once a quarter.
Many of you are probably wondering why I am a bit “light” in the fundamental valuation department.
Yes, I do believe in fundamentals. They are ultimately what drive stock prices. However, there is a catch…
Stock prices are based on future expectations of cash-flows/profits. I’ve learnt this lesson the hard way over the last 20 years. In the end, I think Druckenmiller is right. Here is an excerpt from an old Barron’s interview way back in 1988:
We look at the market in three different ways – and each of them is flashing warning signals. First of all, we look at valuations. We use them to determine, really, the market’s risk level, as opposed to its direction. Valuation is something you have to keep in mind in terms of the market’s risk level. When catalyst’s come in and change the market’s direction, the decline could be very major if you’re coming from the kinds of overvaluation levels witnessed in 1929 and the fourth quarter of last year [note: this was in the year following the 1987 crash]. So, valuation is something we keep in the back of our minds.
The major thing we look at is liquidity, meaning as a combination of an economic overview. Contrary to what a lot of the financial press has stated, looking at the great bull markets of this century, the best environment for stocks is a very dull, slow economy that the Federal Reserve is trying to get going.
Once an economy reaches a certain level of acceleration, the Fed is no longer with you. The Fed, instead of trying to get the economy moving, reverts to acting like the central bankers they are and starts worrying about inflation and things getting too hot. So, it tries to cool things off, shrinking liquidity, while at the same time the corporations start having to build inventory, which again takes money out of the financial assets. Finally, if things get really heated, companies start engaging in capital spending…
All three of these things, tend to shrink the overall money available for investing in stocks and stock prices go down.
While we may talk of current ROAs, dividend yields, and PE ratios, the most important thing is what will be those yields/ratios a couple of years from now.
So, to get an edge on the crowd one needs to be able to anticipate what the crowd is going to anticipate.
To cut straight to the point, I’m anticipating that eventually the crowd will anticipate large write downs with Australian banks: what have recently been record profits will eventually turn to significant (if not record) losses.
What is currently being priced in by the market?
P/Book ratios at Australian banks range from 1.5x to 1.9x. For US banks 1x to 1.5x, for Japanese banks about 0.6x, and for Singaporean banks about 1.0x.
Clearly the market is still pricing in a way rosier economic outlook for Australian banks compared to other world banks.
My gut feeling here is that the best trade here will ultimately be long Japanese banks and short Australian banks. However, I have to hold myself back from doing that as my objective in this trade isn’t to bet on which geographical region will outperform Australian banks, but it is that the valuation differential between Australian banks and world banks will close over the coming months and years.
Below are the performance charts of BAC, DBS, and Sumitomo bank relative to Commonwealth Bank, Australia’s biggest bank and a proxy for the banking sector. Unfortunately, the ASX bank index doesn’t go back very far. All the prices are in USDs so there is no currency effect.
Granted there is more to investing than the “angle of a chart”. However, the charts do suggest that the long trend of underperformance of world banks relative to Australian banks has come to an end.
BAC Relative to CBA
The ultimate bottom was reached in 2013 and has quietly been tracking higher ever since. The beauty of these relative trends is that they tend to be a lot smoother than absolute trends. It seems that BAC is prospering as rates rise but Australian banks are suffering.
Remember also that in the ‘08 crisis the US banking sector was recapitalised. Sure, tax payers footed the bill and that sucks for them, but the fact is that US banks are in far better health than their Australian counterparts.
It certainly seems that there is a very strong relationship between how the US 2-year yield is behaving and BAC relative to CBA.
Sumitomo Bank Relative to CBA
Japanese banks have suffered ever since the euphoric days of the late 1980s. However, against a backdrop of low to no interest rates Japanese banks are now managing to make respectable profits while trading at crazy low fundamental valuations. Sumitomo (Japan’s second largest bank) trades on a P/Book of 0.61 and a P/E of 9x with a dividend yield of almost 4%.
Look at that trading range below, from 2010 to now, and you’ll notice Japanese banks have matched the performance of Australian banks. In that time Australian banks couldn’t have had it any better but no one would dare talk about Japanese banks.
DBS Relative to CBA
DBS is Singapore’s biggest bank and we’re using it as a proxy for Southeast Asian banks. For 17 years it underperformed CBA but now that trend has begun changing.
From 2010 to mid-2017 DBS relative to CBA traded in a narrow trading range… but over the last 12 months has outperformed CBA (Australian banks in general) significantly. Yes, it would have been nice to have got onto this trade 12 months ago, but there has been a bit of a pull back as of late which affords one an excellent level to enter the trade.
Why the recent pull back? I believe it is essentially over fears of the “trade war” between the US and China. DBS has a reasonable exposure to China through Hong Kong (Hong Kong’s fifth biggest bank). DBS doesn’t have a large exposure to the Singapore property market (only about 20% of its book compared to Australian banks, which have some 60% exposure to the Australian property market).
The Hardest Part of the Trade
As Tom Petty once said, the waiting is the hardest part. Sure, we have done OK on the long IXG, short Westpac trade so far, but we believe it’s time to press this trade now.
I love the quote from Rudiger Dornbusch:
The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.
Founder & Editor In Chief, Capitalist Exploits Independent Investment Research
Founder & Managing Partner, Asymmetric Opportunities Fund
Unauthorized Disclosure Prohibited
The information provided in this publication is private, privileged, and confidential information, licensed for your sole individual use as a subscriber. Capitalist Exploits reserves all rights to the content of this publication and related materials. Forwarding, copying, disseminating, or distributing this report in whole or in part, including substantial quotation of any portion of the publication or any release of specific investment recommendations, is strictly prohibited.
Participation in such activity is grounds for immediate termination of all subscriptions of registered subscribers deemed to be involved at Capitalist Exploits. Capitalist Exploits reserves the right to monitor the use of this publication without disclosure by any electronic means it deems necessary and may change those means without notice at any time. If you have received this publication and are not the intended subscriber, please contact firstname.lastname@example.org.
Capitalist Exploits website, World Out Of Whack, Insider, and any content published by Capitalist Exploits is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. The information contained in such publications is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in such publications are those of the publisher and are subject to change without notice. The information in such publications may become outdated and there is no obligation to update any such information. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.
Capitalist Exploits and other entities in which it has an interest, employees, officers, family, and associates may from time to time have positions in the securities or commodities covered in publications or the website. Corporate policies are in effect that attempt to avoid potential conflicts of interest and resolve conflicts of interest should they arise, in a timely fashion.
Capitalist Exploits reserves the right to cancel any subscription at any time, and if it does so it will promptly refund to the subscriber the amount of the subscription payment previously received relating to the remaining subscription period. Cancellation of a subscription may result from any unauthorized use or reproduction or rebroadcast of any Capitalist Exploits paid publication/s, any infringement or misappropriation of Capitalist Exploits proprietary rights, or any other reason determined in the sole discretion of Capitalist Exploits.
Capitalist Exploits has affiliate agreements in place that may include fee sharing. If you have a website and would like to be considered for inclusion in the Capitalist Exploits affiliate program, please email email@example.com. Likewise, from time to time Capitalist Exploits may engage in affiliate programs covered by other companies, though corporate policy firmly dictates that such agreements will have no influence on any product or service recommendations, nor alter the pricing that would otherwise be available in absence of such an agreement. As always, it is important that you do your own due diligence before transacting any business with any firm, for any product or service.
© Copyright 2018 by Capitalist Exploits