Monday, April 18, 2016

Through a Glass Darkly

At first glance, it seemed like just another week of more of the same even with the dollar finding its footing late in the week; equities were up with Brazil and gold miners leading the way higher but beneath the surface a major shift took place.  Investors were quick to overlook the falling revenue and the rejection of their living wills to push bank stocks higher on better than expected EPS but before rushing out to add more bank exposure to your portfolio, consider whether the latest rally is built to last or whether it’s just a castle in the sky.

Given the monumental shift in investor sentiment towards the megabanks last week, perhaps the biggest surprise (or not) in our weekly ETFG Quant Movers Report was the total absence of any banking or financial services funds despite their strong showing with the SPDR S&P Bank ETF (KBE) up a strong 7.2%.  Even smaller banks benefited from the shift in sentiment with the SPDR S&P Regional Banking ETF (KRE) up 7.3% while the more micro and small-cap focused First Trust NASDAQ ABA Community Bank Index Fund (QABA) delivered a nearly 6% return for the week.  For a fund or even sector to miss out on making the list of top movers after strongly outperforming the broader market, you’d expect to find them already holding down most of the top behavioral slots after a prolonged period of strong outperformance.  A prime example of that would be the iShares MSCI Brazil Capped Fund (EWZ) which was up over 7.64% last week but won’t appear in any of our “biggest gainers” lists because strong price momentum (not to mention high volatility and short interest) have kept it at the top of the Behavioral charts for weeks now.

It’s been a long time since strong performance and high momentum have plagued bank stocks as the Fed’s commitment to keeping rates low destroyed the prospects for higher net interest margins while high volatility sapped into their already anemic trading revenue.  The situation had gotten so dire that even after last week’s big rally, the Financial Sector Select SPDR Fund (XLF) still has the lowest price momentum score of any of the select sector funds, trailing even the hard pressed Utilities Select Sector Fund (XLU) whose technical score is 3x that of XLF.  And while you won’t find any of the bank funds on our “100 Funds with Lowest Behavioral Scores” list, you certainly won’t find any in the top 100 fact, not one financial sector fund of any kind is found anywhere in the top 100.  That sort of weak performance usually means the list of biggest quant movers would be dominated by bank stock funds as investors rush to join a new trend but instead KBE, KRE and even XLF saw a continued (if somewhat diminished) outflow of assets last week as investors continued to divest from the sector.

The above has us wondering whether investors are finally starting to think about potential outcomes of the Fed’s policy instead of hoping that the rising tide will lift all boats.  While the mega-banks beat incredibly low analyst expectations thanks in part to improvements in trading revenues in March, the outlook for earnings growth going forward remains dim with lowered expectations for both revenue and earnings growth going forward. The Fed bares most of the responsibility thanks to its stated intention to only raise rates at a gradual pace is hardly reassuring and Janet Yellen’s extensive use of the word “uncertainty” in her speeches isn’t helping restore investor faith in the sector which surely explains why more interest rate sensitive small banks underperformed larger institutions last week.  Meanwhile even the most ardent bull will admit that the recent equity rally is likely to prove to be on a brief respite, especially given the political calendar that includes the upcoming Brexit vote and U.S. presidential elections.  And even beating those lowered expectations couldn’t completely obscure this week’s negative reports including that failure of five “too big to fail” institutions to deliver living wills to satisfy both the Federal Reserve and FDIC concerns about future bailouts.  Given that it’s an election year, we’ve probably only just heard the beginning of the diatribes from both sides of the aisle on the need to reduce the risk or even break-up the banks.

As long as equity sentiment remains positive, bank stocks should continue to feel the wind at their backs although the next news report to watch is the outcome of Sunday’s OPEC gathering in Doha to debate a production freeze although expectation for success are fairly low and the potential financial fallout is extreme.  According to the WSJ, the recent Chapter 11 filing by Goodrich brings the number of bankruptcy filings by energy firms since 2014 to 60 with over $20 billion in debt affected and even larger banks are beginning to feel the pinch. JP Morgan and BofA are feeling the pinch with both doubling the amount set aside to cover future loan losses in the energy sector with both banks now having reserves in the billions on expectations of even more pain to come.  So to recap, higher loan loss reserves and lower profit potential…no wonder investors are using this latest rally as a chance to further de-risk their own portfolios of bank stocks while they still can.

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