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 theyre either slipping down or at best staying around their current level. That in itself keeps me away from the big banks, but theres another even more powerful reason for me to keep bank shares at arms length.

Caution is needed

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

For the last two years or so Ive 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 youre picking your own shares to invest in.Lynchs advice is the best on cyclicals Ive 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, theres danger that a value-investors or an income-seekers toolkit will let you down when it comes to cyclical investments such as this.

Lynch saysthat 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 theyre 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 doesnt 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.

Ive been following Peter Lynchs mid-macrocycle advice for a couple of years now. Its 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 thats 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.