Avoid The Banks, For Now

It takes a brave person to question the investment quality of our major banks. Often the cornerstone of many an investor's portfolio, they have underpinned phenomenal wealth creation over an extended period of time.

The Commonwealth Bank (ASX:CBA) is probably the best example; shareholders have enjoyed an incredible 1,588% total return (including dividends) over the past 20 years, with the GFC barely registering as a blip on the screen when looked at in context.

Personally, I think our major banks will continue to be around for decades to come, and will prove to be an important source of wealth creation. That being said, I don't think now is the time to load up. There is a number of factors that are almost certain to make the next decade much more hard going than the previous…

For starters, the demand for credit — the bank's core product — is likely to be lower in the years ahead. The insatiable demand for property means many Australians are already levered to the eyeballs; many simply don't have the capacity to further extend their borrowing. At least, not without the 'free-kick' you get from the increasing equity that rising values unleash, but there are affordability constraints that will likely limit that from here.

Next, we have to account for the increased regulatory burden the banks are facing. Tighter capital adequacy rules and the newly proposed bank levy will act to erode the profitability of banks. Of course, on their own these don't turn a great company into a poor one, but it will handicap growth prospects going forward.

And then there's the prospect for disruption, with everyone from Apple (NASDAQ:AAPL) to nascent start-ups all looking to claim a piece of the action for themselves. While I think much of the potential here is sometimes exaggerated, it's also true to say that the banks' have never been under more pressure from new entrants.

In an ideal scenario, these factors will only act to dent the banks' growth rate, and they'll continue to muddle their way through these issues. In that case, they are reasonably priced and shareholders could expect 'market average' -type returns in the coming years.

On the other hand, the downside potential is more significant. While I'm not calling for a recession, we have to remember that that is always just a question of 'when', not 'if'. With nearly 26 years without any meaningful economic slump in Australia, we tend to forget just how cyclical banks are. In fact, banks are typically among the most sensitive to economic conditions!

With limited growth and upside and the potential for nasty (albeit likely temporary) losses, the banks just aren't a compelling proposition at present. That's not to suggest all investors should dump all their bank shares, but I would encourage people to consider their exposure, and to expand their horizons when looking for attractive income stocks.