A Race Against Time

Bullish sentiment at the beginning of a new year is nothing new. It seems like every January, expectations are reset and people become more hopeful regardless of any volatility in the recent past. It kind of reminds me of Redskins fans. No matter how bad the team gets (4 and 12 in 2014), the beginning of each new season brings renewed optimism that a trip to the playoffs is in the cards.

Fortunately for all of us, stocks have had a much better record in recent years than the Washington Redskins. The S&P 500 has more than tripled since the lows of March, 2009 on roughly a doubling in corporate profits over that time frame. Investors with the fortitude to ignore the significant background noise (Europe, Syria, ISIS, Ebola, China, Ukraine, riots, data breaches, etc) have been handsomely rewarded. Yet despite those massive gains, nearly every opinion I hear suggests another year of outsized gains is in store for 2015. It may well happen. I'll be the first to admit that I have no idea what the stock market will do in any given year. But the beginning of earnings season is exposing some cracks in the foundation. The most obvious of those cracks are the bank earnings.

It is not a good time to be a bank CEO. The operating environment has been exceedingly difficult since prior to the financial crisis. Fortunately, most banks have been able to post some modest earnings increases over the past few years through the release of loan loss reserves. What this means is that the reserves that had been set aside to cover bad loans during the financial crisis are now being released and counted toward earnings. Given the massive accumulation of reserves during the crisis, reserve releases have been an ongoing, reliable source of earnings for several years now. But the well is beginning to run dry. As credit losses begin to trough, banks cannot rely on this source of earnings for much longer.

In addition to reserve releases, banks have benefited greatly from the fee income associated with mortgage originations. Low mortgage rates have led to massive refinance volumes over the past few years. Banks earn fees for originating these loans, and then they earn fees for selling the loans to Freddie Mac and Fannie Mae. It has been a huge windfall for banks heavily tied to the mortgage market, but we may see this source of earnings run dry in 2015 as well. So far in 2015, mortgage production is up smartly thanks to the rapid decline in interest rates in recent months. So for at least another quarter, banks are likely to enjoy the windfall that is created by another "refi boom." But how much longer can this last? There must come a point when everyone who can refinance has already refinanced. When this happens we are likely to see sustained lower levels of fee income and another round of layoffs at the banks.

There isn't too much to replace these sources of earnings in the near- to intermediate horizon. Banks are hoping (we'd say praying) that income from mortgages and reserve releases will be replaced by better loan growth, higher interest margins , and lower mortgage servicing costs (to include lower costs to repurchase loans from Freddie Mac and Fannie Mae). Indeed, we are seeing some signs of a pickup in loan growth, but competition for these loans is fierce. Every bank out there is looking for the same high-quality assets so they can put their huge deposit bases to work. As for interest rates, they are trending lower, not higher, and a Fed tightening in 2015 is by no means guaranteed. Moreover, the beginning of aggressive monetary easing in Japan and Europe will likely put a cap on rate increases at the longer end of the curve. All the while, new regulatory requirements for higher capital and liquidity will continue to be a drag on profits and returns.

It is important to note that bank earnings aren't the only drag on earnings that we'll encounter in 2015. A sharp spike in the US dollar is hurting exports and affecting the revenue and earnings for those companies that do business overseas. We are starting to see those effects this week in the earning reports from a number of large, multinational corporations. Also, a massive drop in the price of oil will eat into earnings at the Energy companies, while also eliminating a big source of the recent (well-paying) job gains we've enjoyed.

The year 2015 may yet produce solid returns for investors in US stocks. However, it's looking more and more likely that TINA ("There Is No Alternative"), more than any other factor, will be responsible rather than strong earnings growth. Has investing gotten that simple to the point where we simply need to pick the least bad alternatives? If only that were true! Stay the course. Eschew emotion, and focus on your long-term goals.