Why Flirting With Lloyds Banking Group plc, Barclays plc And Royal Bank of Scotland Group plc Now Is Dangerous

Where are the shares going in 2016 for banks such as Lloyds Banking Group (LSE: LLOY), Barclays (LSE: BARC) and Royal Bank Of Scotland Group (LSE: RBS)?

My bet is that they’re either slipping down or at best staying around their current level. That in itself keeps me away from the big banks, but there’s another even more powerful reason for me to keep bank shares at arm’s length.

Caution is needed

The big banks continue to fascinate private investors. Perhaps it’s those low-looking price-to-earnings (P/E) ratios and high-looking dividend yields that attract. But anyone who has read investing legend Peter Lynch’s advice on trading cyclical shares will surely treat the banks with caution.

For the last two years or so I’ve been avoiding the big banks and it has worked out well with the shares more or less flat. My bearishness started after the big rises that were all done by the beginning of 2014. To me, that looked like the share prices adjusting to accommodate their bounce-back in earnings after the financial crisis of the last decade. I reasoned back then that earnings would be harder to grow after they recovered to pre-crisis levels. So far, that seems sound.

To find out what Peter Lynch has to say on cyclicals, read his book Beating The Street, especially if you’re picking your own shares to invest in. Lynch’s advice is the best on cyclicals I’ve come across and has helped me get a few big calls right in recent years.

Not all they seem

The banks currently look like ‘value’ investments at first glance. However, there’s danger that a value-investor’s or an income-seeker’s toolkit will let you down when it comes to cyclical investments such as this.

Lynch says that when traditional valuation indicators such as P/E ratings and dividend yields look the most attractive, cyclical firms are at their most dangerous for investors. When the indicators look tempting, cyclical firms have often enjoyed a long period of good trading. The trouble with cyclicals is that they’re very responsive to macroeconomic conditions. You only have to look at the recent share price weakness of the banks to see how fast they dip at the slightest whiff of a weakening economy. For good reason, too. When the economy slips, so do cyclical profits and the share prices of cyclical companies.

So, mid-macrocycle like this, the stock market tries to smooth out the valuations of banks and other cyclical firms by gradually compressing the valuations of the underlying businesses, in anticipation of the next collapse in profits with the next macroeconomic down-leg.

It doesn’t work

Try as the market might to iron-out fluctuations, it rarely works well and cyclical firms see their share prices plunging come the next downturn. Lynch reckons we flirt closer with the edge of that abyss the lower the valuation of the cyclicals get.

I’ve been following Peter Lynch’s mid-macrocycle advice for a couple of years now. It’s saved me from the plunge of the miners and oil companies and kept me away from the lacklustre performance of big banks. It also caused me to exit my trade in housebuilders too early, but that’s a small price to pay for the disasters Lynch helped me avoid.

Big banks such as Lloyds, Barclays and Royal Bank of Scotland look dangerous to me now. To invest in them is to flirt with the unknown arrival of the next profit collapse, all for the scant reward of an ever-compressing valuation, which could drag against any dividend gains.

Instead, I'd rather invest in the firms covered in this Motley Fool wealth report. Our top analysts scoured the market to find companies with reliable cash flow, solid trading positions and great prospects. These are some of the least-cyclical firms on the London stock exchange and they offer solid dividend and capital growth potential. You can find out more about them by clicking here

Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has recommended Barclays. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.