First Past the Post

All eyes may have been on American Pharaoh this weekend but despite his major accomplishment, he was wasn’t the only winner last week. The release of last Friday’s Jobs report that saw strong private employment growth and rising weekly earnings helped shift the odds that rate hikes will be coming sooner rather than later and investors were quick to adjust their wagers with interest rate dependent REIT’s and utilities both making new lows for 2015. And while investors were quick to pile into their favorite trades like long dollar, the real winner was a sector we’ve talked about before, regional bank stocks, which have been riding a wave of investor enthusiasm to new highs over the last four weeks.  Positioning yourself for a rising rate cycle might make sense but investing largely comes down to putting your capital to work when the odds are in your favor and we’re wondering what the potential payoff might be for sticking with the heavy favorite.

Regional bank stocks have become the odds-on favorite after they enjoyed a tremendous week thanks to investors who looked to a strong Jobs report for confirmation that pressure on net interest margins might soon be eased. While Bank of America enjoyed a strong 2.44% advance on Friday, the action was more mixed for funds with a focus on the large and mega-cap financial institutions with the iShares U.S. Financials ETF (IYF) up a mere .38% on Friday thanks to a large allocation to laggards like Berkshire Hathaway and other insurance stocks while more mega-cap oriented iShares U.S. Financial Services ETF (IYG) notched up a 1.2% gain on the day.  But the real winners on Friday were those who heeded our March 9th blog posting, “Banking for the Win” because the smaller the average market cap, the better the performance with the S&P SPDR Regional Banking ETF (KRE) enjoying the strongest advance on the day with a 1.89% gain although less enterprising investors chose to make a $2 bet on the PowerShares KBW Bank Portfolio (KBWB), up over 1.8% on Friday and whose average market cap of $39 billion is nearly 6X greater than that of KRE ($6.6 billion.) But before you rush out to join the trend and buy into funds with a microcap focus, consider whether all the investors who came before you have skewed the odds.

Remember that the biggest payoffs always come when the odds are long and investors who ventured into the long-over looked banking sector on March 9th were well rewarded for their bravery with KRE up over 7.8% and KWBW up 6.8% compared to 2.69% for the Financial Sector Select SPDR (XLF) and slightly over 1% for the S&P 500.  And while everyone likes a winner, one of the key ingredients of our ETFG Quant Screening system is fundamental valuations and regional bank stock funds like KBWB, KRE and the SPDR S&P Bank ETF (KBE) made our short-list for funds with the one-day biggest percentage drop in their fundamental scores.  KBWB and KBE both saw their overall fundamental scores drop by more than 20% on the day as investor excitement over the financial relief from expanding NIM ratio’s pushed the price of both funds close to a historic peak on one valuation metric or another.  Both funds are trading at or near their highest recorded price-to-cash flow metric ever recorded while KBE’s trailing P/E ratio is trading in its highest 5th percentile since the fund’s inception (although at 15.34 it still ranks below the broader market with SPY currently at 18.45.) Expanding margins are always good for business, but the real question that has yet to be answered is whether the regional banks will see loan growth expanding at a rate faster than their cost of funds as rising rates are a two way street.

But at ETFG we recognize that relying solely on valuation metrics is somewhat like trying to win a horse race by having the lightest jockey; it can’t hurt but it won’t really be the deciding factor in whether you reach the winners circle.  So switching over to the technical picture for the sector, a quick glance at the charts shows that KBE, KBWB and KRE all find themselves in a very similar technical setup, which is not surprising for KBE and KRE which despite their different benchmarks have a fair amount of cross-holdings between the two funds.  After blistering advances in 2013 that saw all three funds up more than 40%, a Fed induced malaise set in for 2014 as investors pondered the end of QE3 and had many in the media speculating whether the end had come from bank stocks. Hindsight is 20/20 because in retrospect, the regional bank ETF’s now appear to have needed time to digest their strong gains.  All three ran into strong overhead resistance in the first quarter of 2014 as their 14 week relative strength index’s traded well above the overbought level of 70 and needed time to cool off before retesting those levels again close to year-end.  And thanks to the strong growth in employment, all three funds have seen strong buying activity over the last five weeks that’s finally pushed our three funds above that prior resistance and on to new highs.  But with all three RSI scores now closing in on 70, we have to wonder if the easy money has already been made.

Momentum is one of the market anomalies known to persist for extended periods and more fortunes have been lost by short sellers declaring “it can’t keep going up from these levels” than ever were ruined by a long weekend in Vegas but remember the keys to long-term alpha depend on timing and wagering when the odds are in your favor.  Important things to remember before adding long exposure to the Bank of the Ozarks in your portfolio.

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