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By Liu-Yue (Louie) Lam, Co-Founder, CEO, & Chief Investment Strategist, Oxstone Capital Management,

On several occasions during the 2008 to 2009 financial crisis the rates on U.S. Treasury Bond yield were lower than the dividend yield on the U.S. stock market indices.  A similar situation had not occurred for almost 50 years.  Some market commentators expressed that this was a temporary abnormality.  However, others believed that we were returning back to the historical norm.  In the past; equity assets were required to offer investors higher yields than U.S. Treasury Bond yields due to the higher risks involved in equity investing.

Since those turbulent times the question still remains – Are we entering back to a historical norm? Or was it just a temporary abnormality.  There still are really no clear-cut answers.  But I will share with you my own humble opinion.  If I view it through optimistic lenses, I would say that this phenomenon was due to the extreme panic in the markets that had greatly undervalued all equity assets relative to US Treasuries.  Over the past 3 years as risk appetite returned to normal levels; the flight to extreme safety abated.  Risk tolerances have indeed since increased considerably and therefore rationally led investors to compare alternative asset classes; base on risk and reward.  Treasuries were yielding an abnormally low 2%; which would have taken 50 years for investors to make back their money.  This simple risk vs. reward observation should have led most rational investors back into riskier assets such as equities again.  This has since occurred due to a combination of higher inflation expectations and higher risk tolerance as the financial crisis abated.

However, if we look at those abnormalities during the past few years through pragmatic lenses I believe that these abnormalities may have been the beginning of a longer-term trend.  It may possibly be a generational theme partly due to the permanent scars left in the aftermath of this once in a lifetime financial crisis.  The re-introduction of higher equity risk premiums in the form of higher equity yields may be here to stay.  Who can blame the masses of young investors leaving the equity markets for the assumed safety of bonds?  Most are permanently scarred from witnessing first hand – two Bear Markets while investing in equities and earning close to 0% over the past 10 years.  In addition, as Baby Boomers begin to retire over the next two plus decades they will begin to sell off equity assets and other riskier form of investments in order to fund retirement. Therefore it is certainly possible that going forward, investors may continue to demand higher yields to compensate for the perceived higher risks in US equity investing.

I also expect that investors will eventually begin to price in the longer term implications of extreme fiscal and monetary actions taken by our government as we continue to re-inflate assets around the world.  In addition, the longer-term effects of the ongoing asset devaluation in the real estate market which is due to the extreme supply imbalances; simply cannot be ignored as it will most likely continue to lead to stagnant growth for many more years to come.  Much like the difference between value and growth stocks, investors may be pricing in longer-term slow growth for the US economy.  Therefore investors need to be compensated more with dividend yield because the prospect of capital appreciation from growth is simply not realistic.

I think we can already see this longer-term theme toward higher dividend yields impact several sectors.   For example, many banks are beginning to re-introduce dividend payments for the first time in three years.  But I believe the markets are not only demanding dividend payments, but also expect a long term trend in demanding higher dividend yields from all financial institutions going forward because they may be pricing in a higher risk premium for all financial companies.

Since the financial crisis, many unfortunate investors have learned first-hand that financial firms are in fact highly cyclical businesses.  Therefore like other highly cyclical businesses, banks should command a lower market multiple to reflect the inherent volatility of its earnings.

In addition, the banking business model is currently undergoing significant reforms which will most likely make it less profitable going forward.  Due to higher regulation and higher taxation from Financial Reform & Basel II regulatory requirements, banks are divesting of noncore businesses and reverting back to its traditional role as a facilitator of economic activity rather than a creator of economic activity.  While regulators and taxpayers will be pleased that banks are returning back to its traditional banking model of taking in deposits and making loans; this will also significantly reduce its revenue and growth opportunities.   Therefore the contraction of P/E multiples for all financial companies during the financial crisis may have been the beginning of a longer-term trend of re-pricing financial companies for higher regulations, higher taxes, and slower growth going forward.  Thus most financials are now priced in single to low double digit P/E multiples for good reason.

I believe investors should expect bank stocks to behave much like utilities – highly regulated dividend income producers going forward.   I personally believe the only way a financial company may command a higher P/E multiple in the future will be to either change investor perception that a company is less risky because it has an unique business model such as a counter-cyclical business model or to be perceived as generating more stable earnings (for example fee-income model) such as a custodian /trust bank or asset management company.  I don’t believe growth in revenues in the finance industry will be as rewarded by investors going forward because it will be perceived as a riskier model compared to a risk control model as investors are now re-pricing financials as risky, highly cyclical and slow growing businesses.

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