By most measures, the stock market is fully valued, but investors are making a mistake by assuming that the natural result is an imminent downturn in the stock markets.
Companies heavily exposed to consumer finance, such as Synchrony Financial (SYF), Capital One Financial Corporation (COF), and Discover Financial Services (DFS), are in strong position to continue to serve the financial needs of consumers.
Of these, I particularly like Synchrony Financial, which operated as a subsidiary of GE Capital until 2014. Here are the fundamentals of the company’s July 21st (second quarter) financial report:
- Net interest income up 13% Y/Y to $3.6B. Net interest margin of 16.2% up 26 basis points.
- Provisions up $305M to $1.326B. Loans 30+ days past due as a percentage of total loans rises to 4.25% from 3.79%. Net charge-off ratio rises to 5.42% from 4.51%. Loan loss allowance of 6.63% vs. 5.7%.
- Period-end loans up 11% Y/Y, with purchase volume growth of 6% and average active account growth of 5%. Deposit growth up 14%, and comprises 72% of funding vs. 71% a year ago.
Most of the criticisms I read are not about the fundamentals of any of these three companies, but rather the macro environment in which they are operating.
Specifically, investors seem afraid of delinquencies and charge-offs that will hurt their future profits.
While the company has increased its loan loss provisions, concerns about delinquencies are overblown, which is why I think the opportunities for consumer financial stocks, such as Synchrony, are too good to pass up at this point in the economic cycle.
These fears are ignoring the strength of the real economy.
Let’s go through the negatives first:
Government shutdown. It is possible that come Sept. 30, Congress and the President won’t come to an agreement and the Federal government may stop doing business. Less likely that the Federal government will actually default on its debt. Worse case is a delay in payments, but even that is iffy at this point.
In that case, it is likely that the stock market will drop. As has been pointed out elsewhere, that decline might be real but temporary, as in 2013. On Sept. 19, 2013, the S&P 500 was at 1722.34. By Oct. 8, it had fallen about 3.88%. The government reopened in mid-October. By the end of the year, the S&P 500 had risen 11.2% from that Oct. 8 low. An investor has to ask, is this time really any different than in 2013?
What if the government raises the debt ceiling and passes some sort of Continuing Resolution that lets the Federal government continue to operate?
In that case, it is likely that the stock market will drop, if only because investors were expecting a decline. But again, will this decline be temporary or permanent?
I would avoid stocks only if you think the decline is permanent.
The market is overpriced. I agree that valuations are high — higher than I would like and too high to go “all-in” on stocks.
Either earnings have to grow, or stock prices must decline. But neither of those scenarios equal an economic recession.
A selloff in the market will bring down prices to more realistic levels and create a buying opportunity, but we have been waiting for a major selloff for a long time. What if the market just languishes at these levels but the real economy chugs ahead?
In that case, are defensives like Smuckers, the best choice for a growing economy?
We are due for a recession. At an emotional level, I can agree with that statement. The last recession ended in June 2009, so if the business cycle follows a fixed pattern, we are overdue for the next recession.
But recession cycles aren’t fixed in stone. Employment is good, businesses are investing, there is talk of tax reform, and corporations seem to have the upper hand at the moment.
Yes, we could have a nuclear war with North Korea, and yes, we could go to war with China; but if neither of these scenarios occur, what will bring on the next recession?
The case for financials
The American consumer is growing stronger, not weaker. Employment levels are high, not only in the United States, but elsewhere in the world as well.
The Bureau of Labor Statistics’ Employment Situation surprised economists by showing total non-farm payroll employment increasing by 209,000 in July. Employment growth has averaged 184,000 per month thus far this year, in line with the average monthly gain in 2016 (+187,000).
The unemployment rate currently stands at 4.3%. The employment-population ratio (60.2 percent) was little changed in July but is up by 0.4 percentage point over the year.
Here is the GDP over the past five years up to the 2nd quarter of 2017, which came in at an annual rate of 2.6%.
According to the New York Fed’s Quarterly Report on Household Debt and Credit for the first quarter of 2017, total household debt finally surpassed its 2008 peak, and that is nominal debt, not taking into account inflation over the past 9 years.
While auto loan and credit card delinquencies are ticking upward, they are well below the averages over the past 7 years. Consumers are being cautious with their credit, unlike prior to the last recession. I argue that they remember the pain of that recession still and will work hard to avoid delinquencies based on their own recent past experiences.
The Fed reported that “aggregate delinquency rates were roughly flat in the first quarter of 2017, with some variation across product types. Early delinquency flows have improved markedly since the recession, albeit with some slow deterioration in auto loan performance and a more recent uptick in early delinquency on credit cards.”
Student loans remain a problem, but overall, they are small percentage of total consumer debt.
Ahead of the annual Fed meeting in Jackson Hole, Dallas Fed President Robert Kaplan is quoted as saying “While market valuations may be full, I don’t see a build-up yet of excessive debt.”
The Fed did report that “about 203,000 consumers had a bankruptcy notation added to their credit reports in 2017Q1, 1.7% fewer than in the same quarter last year and another record series-low.”
The Federal Reserve may raise interest rates, but only slowly. While the Federal Reserve wants to move towards a more normal interest rate policy, their hands are tied by a combination of low inflation and uncertainty about Federal government fiscal policies.
Inflation remains stubbornly subdued, and the Fed cannot raise rates substantially without more headline inflation. Any gradual raising of rates helps financials as they can increase the spread between borrowing and lending.
This is a great time to loan money with the Fed still supplying low-interest money, while credit card lending rates remain in the 15-20% range.
Meanwhile, the Federal government’s fiscal policies remain unclear, forcing the Federal Reserve to be cautious about any rate increases in case they have to act as firefighters if Congress has a fiscal meltdown. That limits the Fed’s ability to raise rates until they can gain some clarity on Federal fiscal policies in 2018 and beyond.
Financials are due for a bounce. Financials are one of the worst performing groups in the S&P 500, mainly because of unfounded pessimism about the economy. That positions them perfectly for a bounce even if the overall market flattens.
Of this group, Synchrony stands out because it is a purer play on the consumer. Synchrony Financial shows a current P/E under 12 and a dividend yield of near 2%. It is posting a Return on Equity of 16.80.
Unless you think the consumer is going to repeat their pains of 2008-2009, this company is in a great position for the future.
I could go on, but I have gone on too long for many readers already.
This article was prompted by a previous article authored by John Rhodes (“Goodbye American Express, Hello Smuckers”) where he sold American Express (AXP) and chose to buy J.M. Smucker Co. (SJM) instead of Synchrony Financial.
His reasons included “I am overweight in financials and wanted to get more exposure to consumer defensive and recession-proof food,” but he is passing up a bargain at these prices by not buying consumer finance companies such as Synchrony Financial, Capital One Financial Corporation, and Discover Financial Services, which are most exposed to the American consumer.
If he wants diversity, than he can choose other financial stocks less tied to the consumer, such as Bank of America (BAC), JP Morgan Chase (JPM) or Citigroup (C), but then you are exposing yourself to other problems such as risks in emerging markets and economic and fiscal uncertainties related to China.
If pessimism about the American economy proves unfounded, as current economic data indicates, then I can only hope that people stay pessimistic long enough for me to buy more financials at these levels.
Disclosure: I am/we are long SYF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I purchased SYF after reading John Rhodes’s article on why he was avoiding this stock.