I’ve been writing only bearish articles about Lloyds Banking Group (LSE: LLOY) for a few years. It occurred to me at the end of 2013 that the rapid upswing in the share price relating to the firm’s operational recovery could be over.
So far, that theory has played out because there’s been no big surge higher for the share price from its level of around 82p five years ago, despite a dramatic recovery in earnings.
A shrinking valuation
I’ve maintained the argument that the stock market would be likely to gradually mark down Lloyds’ valuation as earnings grow because of the firm’s cyclicality. Lloyds is a commodity-style enterprise that relies on the fortunes of its customers, such as individuals and companies, in order to thrive. If Lloyds’ customers do well, Lloyds will do well. But if the economy takes a dive and Lloyds customers begin to struggle, I reckon its profits will plummet along with the share price and dividend.
It was well-known, one-time US fund manager Peter Lynch who alerted me to the idea that the valuation indicators of banks and other cyclicals are best interpreted differently than we usually do for a trading company. He argued in his book, Beating the Street, that for the big banks and other cyclical enterprises, a high dividend yield and a low price-to-earnings (P/E) multiple can be indicators of POOR value when they come after a sustained period of robust and rising profits. He reckons that the low valuation is the market’s way of trying to adjust for the probability of lower earnings down the road when the economic cycle turns downwards.
I reckon we are seeing that scenario with Lloyds now. But what will happen next? Lynch suggested that there would be a big risk to the downside because big profits usually cycle down to smaller profits in the end. When that happens, the share prices of cyclical firms tend to plunge, despite the way the market has been trying to peg the valuation.
This is what I want to see
But have I been wrong about Lloyds’ share price all along? After all, many commentators disagree with my stance. They point out the ‘value’ displayed by those tasty-looking indicators and the stock is up around 13% this year already, close to 56p. Maybe we’ll see a sustained rise that takes the shares beyond the summer 2015 peak around 87p? Maybe, but I’m sceptical about that. City analysts are predicting flat earnings for 2019, which lends more weight to the ‘peak earnings’ argument, as I see it. Indeed, the next move in earnings could be down.
And that’s what I’m waiting for with Lloyds. I want to see earnings plummet before I’d entertain going bullish on the shares again. If earnings fall off a cliff, causing the P/E multiple to shoot up, I’ll have much more confidence in buying the fallen share price. Right now, we only have a weak share price with earnings remaining robust. Lloyds is just too dangerous for me, and I certainly won’t be buying the shares on the strength of the dividend alone. I’m holding fast with my bearish view on Lloyds for the time being.