Europe Becomes Bullish Tailwind For Financial Stocks

Includes: EWG, EWP, IWM, SPY, XLF
by: Jaimini Desai

The financials have had quite an interesting journey over the last 4 years. Using the Financial Select Sector SPDR (NYSEARCA:XLF) as a proxy for the group, it has rose approximately 210% since the March 2009 bottom. In between, the sector had an almost 40% correction due to concerns about exposure to Europe.

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Unlike the indexes which steadily marched higher over the last 4 years, many financial stocks topped out in late 2009 or early 2010 and basically spent the next years in consolidation. Typically, the stocks with most exposure to Europe were relatively weak, while the performance of European banks was atrocious with many moving steadily lower until systemic risk was off the table via aggressive central bank action.

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This is a good example of the trajectory of European banks. Impressive rally out of oversold conditions in March 2009 but as concerns about Europe grew in the markets, banks with the most exposure were mercilessly sold off. In fact, the severity of the sell-off roughly correlated to the bank's exposure to Europe. In the U.S., regional banks with little international exposure held up well.

With many of these banks in free fall during the Summer of 2012, there were serious questions swirling about the viability of the euro and EU. Interest rates in Spain and Italy were threatening to take the country into default. Europe seemed paralyzed politically and although the market was trending down, futures would wildly gap up or down based on rumors.

Finally, the ECB provided clarity by pledging unlimited bond buying to cap the rising interest rates of countries like Italy and Spain. After the Draghi put was announced, the trend has finally reversed. Interest rates on the Italian 10 Year Bond have dropped from a peak of 7% to around 4% today. Similarly, interest rates on the Spanish 10 Year Bond have dropped from 7.5% to 5%.

The following charts show development.

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The market has decided that, at least for now, the question of Italian or Spanish default is off the table. The bond auctions which during the summer months were going very poorly have been recently marked by strong demand - one sign of confidence returning. One of the lessons from 2007-2009 is that once confidence is gone from the system, then all bets are off. And companies with leverage, such as banks, will be the most punished.

It seems fair to say that in the near term, the worst case scenario is off the table. With the EU debt crisis pressuring banks all over the world, now that the situation seems to be getting better, this removal of risk has been a bullish tailwind for bank stocks. I'm sure many panicked and sold their bank stocks during the crisis. This leads to diminished supply at higher prices and people possibly chasing higher prices.

Much bearish data is coming out of Europe with even Germany slipping into negative growth territory. There are terrible structural problems in the eurozone with many disincentives for people to pursue work or productive activities. This is exacerbated by the weak economy which makes supporting the massive welfare state even more difficult. On top of this is a volatile mix of politics, an aging population, and brewing conflicts between ethnic groups and classes.

However, the markets have been very strong over this same period. In my opinion, this is due to the removal of the risk of currency or union failure.

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This is a chart of the German Index (NYSEARCA:EWG), which is approaching lifetime highs. The market's optimism has been somewhat corroborated by better than expected recent data which remained negative but was better than expected. In comparison, the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) is about 5% below lifetime highs.

The Spanish Index (NYSEARCA:EWP) is well below its recovery high, however since the bottom it is up around 33%.

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However, these countries are still struggling with huge unemployment, especially youth unemployment, for example in Spain youth unemployment is around 50% with unemployment at 26%. On top of this in order to acquire funding from the ECB and EU to assist with the debt crisis, they have been forced to cut back on spending and raise taxes which in the short term will hurt unemployment further.

Take Away

It seems that the big question now is whether or not this move is sustainable or are we near the terminal stages. I have outlined my reasoning for why I think this rally is capable of lasting longer and reaching higher in this article. Further, I believe the market is anticipating better economic conditions in the future which would benefit the banks, given the new all time highs in the iShares Russell 2000 Index (NYSEARCA:IWM).

This rally, internally, consists of impressive participation amongst all types of stocks across numerous sectors. Another positive data point for banks is that housing seems to have turned the corner at least in the short term. This will lift the values of many assets on the banks' books as well as generate an increase in business activity. Finally, the recent earnings reports have been quite promising for banks, especially as they continue to trade at depressed price to book levels based on historical norms. Of course, this higher risk premium may be one permanent consequence of the 2007-2009 period.

In March 2009, the gradual removal of systemic risk via the Fed's aggressive liquidity programs and the Treasury's public intention to not nationalize banks proved to be a stellar buying opportunity. Many of the most oversold bank stocks increased by multiples, once the threat of nationalization and bankruptcy was off the table. I believe we are seeing the same phenomenon today due to the worst case scenario being taken off the table in Europe. Although the move may be halfway complete and due for a correction in the short term, over the intermediate term I think this move higher is still in the middle innings.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.