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Is it time to short Australia’s Big Four Banks?

Investors aren’t going to stop buying shares in the banks anytime soon.

After all, the Big Four have generated huge profits for investors over the years, whether it be in the form of capital gains or fat, fully franked dividends. Many will find it too difficult to look past those historic returns – to fall out of love with something that has been so good to them – to break that connection and sell their shares.

What’s more, the country’s major banks account for more than a quarter of the entire S&P/ASX 200 (Index: ^AXJO) (ASX: XJO). As such, they’re still going to be snapped up by fund managers around the country – particularly those looking for solid dividend yields at a time of low interest rates – while self-managed super funds (SMSFs) will no doubt continue to hold on as well.

Although the major banks are still likely to form a major part of many investors’ portfolios, there are reasons to be cautious.

Over the weekend, The Wall Street Journal noted that hedge funds are increasingly betting against the big four banks, suggesting they may be headed for trouble. Here’s how The WSJ put it:

Rising bad debts, falling earnings and fears of a property-market downturn have triggered a record number of “shorts” on Australian banks, which have long been stock-market darlings because of their high shareholder returns. Short sellers borrow shares from other investors and then sell them in the hope of buying the stock back at a lower price, turning a profit.”

That activity comes even after the falls endured by the banks over the last year. In that time, Commonwealth Bank of Australia (ASX: CBA) shares have fallen 6%, while Westpac Banking Corp (ASX: WBC) has fallen 7%.

But that’s nothing on the losses experienced by National Australia Bank Ltd. (ASX: NAB) and Australia and New Zealand Banking Group (ASX: ANZ), which have dropped 17.9% and 21.7%, respectively.

In addition to the reasons noted by The WSJ above (falling earnings and fears of a property market downturn), there are other catalysts behind the banks’ recent falls.

To begin with, impairment charges and bad loans have fallen to record lows due to the low interest rate environment, driving earnings higher. But more recently, there have been signs that the trend may have reached a turning point which could constrict earnings growth in the future.

There’s also tougher regulations to consider which could impact the banks’ ability to continue growing, or even to maintain, their dividend payments to shareholders in the coming years. To borrow another line from The WSJ, which quoted Man Group portfolio manager Nicholas Vidale as saying:

One doesn’t have to be overly negative to expect Australian bank earnings growth to stall. Dividends are likely to be higher than what the banks can sustain.”

In other words, just because the banks have historically rewarded investors with strong capital gains and dividends, doesn’t mean the same will always ring true.

Foolish takeaway

It should be noted that this is by no means the first time investors have cast their doubts over the banks. Many have been proven wrong, over time, and this situation may prove to be no exception. After all, with interest rates tipped to fall even further from their current 1.75% level, there is a chance the banks’ shares could rise from here.

But at their current price tags, investors need to consider if they are worth holding onto. That’s not to say investors should rush out and sell all their bank shares. But they should certainly be mindful of diversifying away from the banks to ensure they aren’t overly exposed to any of the risks that are currently facing the sector.

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Motley Fool contributor Ryan Newman has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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