Why Lloyds Banking Group plc could be flashing a warning for 2018

Has there ever been a more frustrating stock than Lloyds Banking Group (LSE: LLOY)?

After its big run-up during 2012 and 2013 from a share price in the low 20ps, the stock traded a little higher than 80p at the beginning of 2014. Since then, over the past four years it’s moved sideways, going almost as high as 90p in 2015 and as low as 50p in 2016.

Great expectations

For almost the whole period of that sideways action there’s been great expectation in the air. Many believed the stock would surely rocket at some point, but it never did, and now I reckon it’s looking more dangerous than at any time since before last decade’s credit crunch and could be flashing a big warning for 2018.

The stock might have moved sideways, but business has been booming. Pre-tax profit has moved from £415m at the end of 2013 and looks set to come in around £7,391m this year. That recovery hasn’t benefited shareholders much, though. One reason for that is dilution. In 2013 the company posted earnings per share (EPS) of 6.6p, in 2017 earnings are on course to hit 7.8p, which isn’t the dramatic recovery in EPS many were hoping for.

Another reason for lacklustre shareholder returns is ‘valuation compression’. In 2013 the price-to-earnings (P/E) ratio stood close to 12. Today, it’s somewhere between eight and nine. I reckon that’s normal for out-and-out cyclical firms such as the mainstream British banks. The market tends to mark down the valuations of cyclical shares as the profits of the underlying businesses increase in an effort to anticipate lower earnings down the line.

A proven method of losing half your money

However, the market rarely gets this calculation correct, and share prices often have to adjust down too in order to achieve a fair valuation at lower profits. That’s why I’m mindful of one-time super-investor Peter Lynch’s advice:

 “Buying a cyclical after several years of record earnings and when the p/e ratio has hit a low point is a proven method for losing half your money in a short period of time.”

And Lloyds’ valuation is starting to look tempting, at first glance. After a long period of absence, the dividend is back with a vengeance. The forward yield for 2018 knocks on the door of 7%. But I consider anything near a 7% yield to be more of a warning than an attraction, and that warning is flashing brightly now with Lloyds, to my eyes. The signs are there: recovery in pre-tax profits appears to have stalled and City analysts predict a broadly flat outcome in profits for 2018.

Why risk it?

Meanwhile, economic and political headwinds are gathering and 2018 could be a stormy year. These things are hard to judge, but we do know that by the end of 2018 Lloyds will have put in five continuous years of decent earnings and the forward P/E ratio sits quite low around nine. Why take the risk? The stock has been moribund for four years now, so why will it suddenly shoot up from here? I see much more risk to the downside than opportunity to the upside…