The status of the big banks led me to think about the famous opening phrase of the Charles Dickens novel, A Tale of Two Cities, “It was the best of times, it was the worst of times,” as we face the risks of a pandemic economy.
This week, Wall Street focused on big banks, which largely passed their annual financial stress tests. That’s normally good news, because it means that the U.S. financial system remains resilient enough to survive the worst conditions that federal regulators could realistically contemplate.
But with the economy in a more fragile state than even that “severely adverse” scenario, it’s faint comfort. Reality will be the true test.
And there’s a real chance that some banks which have historically been considered “too big to fail” will, in fact, fail.
Are Big Banks Dead Money for Now?
The Federal Reserve tests the banks regularly to minimize the odds of a repeat of the 2008 credit crisis where Bear Stearns, Lehman Brothers and many smaller institutions collapsed.
In theory, if the banks pass the tests, they can weather anything. But because nobody was expecting months of nationwide quarantine, a lot of existential questions remain unanswered.
After all, the model only tested whether bank balance sheets could hold up to a 6.1% unemployment rate and a 9.9% economic contraction. With the jobless rate hitting a high of 14.7% in April, we’re already beyond that pessimistic scenario.
While some people are convinced that the recovery will be fast and furious, others suspect that unemployment will remain above 10% until late 2021, in which case the banks are looking at another year on what amounts to life support.
Big Banks Now Face New, Toughened Stress Tests
Either way, the old tests are useless now. So, the Fed came up with a new set of post-pandemic scenarios to forecast the recovery that we talk about every week on my “Millionaire Maker” radio show. (Click here for recorded episodes and local stations.)
The most likely scenario in my mind is the most optimistic, with the economy starting to grow again in the next few months. While there will be setbacks, the pain will be over relatively quickly.
If, however, the virus comes back with a vengeance this winter, we could see a secondary recession play out across 2021, with unemployment remaining high and loan activity in decline. That’s a future we all want to avoid.
Fast or slow, the Fed is now prepared for the possibility that bank profits have not bottomed out. If they fall further, dividends and share buybacks need to be cut alongside them.
This is just common sense. Borrowing money in order to make shareholders happy is never sustainable in the long run. Bank executives know this better than anyone.
Banks are just like other companies. When the cash going out is higher than the cash coming in, they’re in trouble. The Fed wants to avoid trouble, and investors should steer clear as well.
Rules for the Post-Pandemic Portfolio
Currently, all the biggest banks except for Wells Fargo & Co. (NYSE:WFC) are bringing in enough cash to cover their existing shareholder obligations.
If you believe, like I do, that the economic disruptions are largely over, you could do well locking in the current dividend streams on JPMorgan Chase & Co. (NYSE:JPM) and Goldman Sachs Group Inc. (NYSE:GS) in particular.
Those stocks currently pay yields of 3.9% and 2.6%, respectively. Lock those rates in. It would take a massive economic shock to interfere with that quarterly income stream.
But don’t count on either stock soaring over the next few years. Remember, the Fed has signaled that interest rates won’t budge above zero before 2022. This cuts the banks off from their primary growth source.
Slack growth makes substantial capital gains mathematically implausible. And as a result, while we can trust these companies to pay dividends, I urge investors to treat them more like bonds than stocks.
Make room on the fixed income side of your portfolio for JPM and GS. Take them out of the equity side if they’re already there.
The goal here is simple. The Fed doesn’t expect long-term Treasury yields to rise above 0.9% for the foreseeable future. So, if you can find something reasonably reliable that pays more in the interim, it’s worth locking it in.
This has implications elsewhere in the portfolio, of course. While some stocks will shift to a bond role, other stocks will remain valuable for their growth profiles and upside potential.
This is why Big Tech has performed so well and why the smaller and more speculative end of the market has already shaken off the coronavirus correction. Growth is still in high demand. If anything, with so many companies stalling, expansive business models are worth more than ever.
We track the brightest of those companies in my IPO Edge service. One in particular, Alkaline Water Co. Inc. (NASDAQ:WTER) is doing so well in the post-pandemic economy that it deserved a special in-depth report. Click here to see it.
Stocks like WTER still deserve to be treated like stocks. Shareholders will get a wild ride, but as long as the underlying business remains expansive, the roller coaster will ultimately point up.
The big banks, on the other hand, have hit a growth wall. While I don’t see them going away or being forced to cut their dividends, they probably won’t make a lot more money in a zero-rate world.
We’ll talk more about stocks like WTER over the next few weeks. They’re my real focus, as everyone who knows what we do in GameChangers can confirm.