Brainstorms: Regional Banks

Regional Banks are NOT a good buy

Quick thought on regional banks:

• Ever since Buffett bought the big banks in the depths of 2008, everyone thinks it's cool to buy anything that falls 50%, even if it's complete trash. We saw this during COVID when people thought it was smart to buy airlines. They are still in the same range!

• What is the moral of the story? Future expected returns are not dependent on how much the stock price has fallen. They are dependent on the future cash flows and how the market is pricing those future cash flows.

• What does this mean? If the stock price falls 50% and the underlying cash flows of the business haven't changed, then of course the stock is undervalued. In reality, future cash flows are in a constant state of change, as is how the market is valuing those cash flows. This means if you are buying a stock, you are taking a view on two things: 1) the future cash flows of a business, and 2) how the market will price those cash flows.

All of this brings us to regional banks. Here is a chart of the regional banking ETF. Nasty chart. It is almost back to the COVID lows.

Will regional banks recover? Let me explain several things about regional banks right now.

• First, the government has made it clear that they are only backstopping the big banks. We saw in the most recent earnings releases that the big banks actually surprised to the upside because their deposits increased. Everyone is thinking, "Why would I put my money in a regional bank if it has the slightest chance of failure?" So they are taking their deposits from regional banks and putting them in the big banks.

• Second, regional banks hold a lot of assets directly connected to the real economy, and we haven't even entered an official recession yet! So we are moving into a period of time where credit spreads are likely to rise, and you're telling me you want to buy a sector that is directly connected to this risk?

• Third, who is to say the KRE ETF can't break below the COVID lows? There is no rule that says it can't.

• Fourth, when I think about the future cash flows regional banks can generate, I don't see them improving dramatically. If anything, I see more consolidation in the financial sector. On top of this, as long as we have credit spreads expanding, there are much better sectors to buy that are likely to outperform regional banks.

A key thing to always keep in mind is opportunity cost. Many people will see the regional bank headline and think they should buy it. You need to stop for a moment and think about if that is the best opportunity in the market right now. There could be an undervalued or mispriced sector somewhere else whose cash flows aren't in significant jeopardy.

Bottom line, I am not a buyer of regional banks here. If the situation begins to change in the future, then I will change.

Thanks for reading!