Markets have been jittery, and airways have been filled with angst. Tech stocks, biotech stocks and other high-fliers of the recent past have been falling in price. Some of the more dramatic winners of yesteryear are losing money to more conservative blue-chip names and bonds. This has been a clear "risk-off" start to the year.
While volatility has increased, we don't agree with the intense level of hand-wringing. In fact, we think that the year has opened rather well. After years of solidly up markets, investors seem surprised that markets will from time to time go down. As older hands, we are well aware that markets go down. Yet, this market really hasn't gone down much. The first quarter ended up just over 1 percent for the S&P 500. After a 32 percent gain in the previous 12 months, a sideways market breather strikes us as a desirable outcome.
While prices move sideways, earnings, in general, are slowly increasing. As they increase, fundamentals improve as price-to-earnings ratios move lower. We will be very pleased if P/E ratios move a good deal lower as a result of earnings growth rather than a drop in stock prices
In a process that has been ongoing for several years now, the Federal Reserve is doing something very important that is not really receiving the attention it deserves: they are requiring banks to operate with significantly more capital and liquidity. Earlier this year I was speaking with a Fed official who discussed these regulatory changes with me. He suggested that the major banks required more supervision and regulatory time because they were so complicated and because they were systemically important. He suggested that capital and liquidity requirements should be raised, effectively resulting in a tax on these institutions to cover the expense that the complexity of their massive sizes required.
On Tuesday, Federal Reserve Chair Yellen said the following:
Federal Reserve staff is actively considering additional measures that could address these and other residual risks in the short-term wholesale funding markets. Some of these measures -- such as requiring firms to hold larger amounts of capital, stable funding, or highly liquid assets based on use of short-term wholesale funding -- would likely apply only to the largest, most complex banking organizations.
While she doesn't discuss any tariff, she clearly seems to be in favor of imposing additional capital and/or liquidity surcharges on the largest and most complex banks. All of this is an attempt to address too-big-to-fail, but we worry about the risks. If the Fed continues to increase capital and liquidity requirements and imposes some sort of progressive tax commensurate with the size of the institution, the Fed will be defining an economically ideal size for a bank. This means that beyond a certain size, the returns for growing a bank will diminish. The net effect may be that these regulatory changes are choking off the supply of credit when it is needed most.
I asked my regulator friend why they wouldn't come out and say what sort of size is comfortable and appropriate from the Fed's perspective. I was told that this approach would hint of central planning, which is an anathema for proponents of free-markets capitalism. I argued that the effect would be the same, and that they should own the outcome no matter how derived. Perhaps I'll never make it as a politician.
These new approaches to bank regulation, to include Dodd/Frank, the Volker rule, Basel, etc., severely limit the operating scope and profit potential of these financial giants. It may indeed protect the US financial system but will also make for much less attractive investments. So far this year, the mid-cap banks are outperforming their behemoth cousins, and we now may know why. The big question, though, is how detrimental have these new regulations been to the economic recovery?
We are living in times of great change and volatility. Don't let the noise get to you, but do your homework and focus on the long-term. In the fish market, one is best counseled to ignore the yelling and pay attention to the price of fish!
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