The entire stock market is clearly facing headwinds amid various domestic and international factors. Standard & Poor's downgrade of the U.S. long term credit rating was only the latest problem facing financial markets. Among other things, the rating agency pointed to their belief that the "effectiveness, stability, and predictability of American policymaking and political institutions have weakened." While they go out of their way to stay politically neutral on the debt ceiling debate, their actions speak louder than words and the downgrade should continue to put pressure on a financial market that was already reeling from a tough August.
Financial stocks, especially the large U.S. banks, have been some of the hardest hit stocks in the market. The Financial Select Sector SPDR (NYSEARCA:XLF) closed at $13.43 on Friday, down 15.3% for the year. Some notable components in that ETF, including Bank of America (NYSE:BAC) and Citigroup Inc. (NYSE:C), have fared much worse. Still, despite the turmoil, there is reason to believe that the bank stock sell-off has been overdone. During the sell-off in common equity, preferred and trust preferred equities for the same bank issuers have remained fairly subdued. Because of the common trades subordinated to the preferred securities, this pricing likely signals preferred shareholders may still believe in the solvency of the banks even if the companies face dilution risks down the line. Investors would be wise to follow the price action across the full capital structure of each issuer. Continued strength in the preferred securities could be a positive sign, but if the jolt in Friday trading among preferred bank shares is a trend, this could spell trouble down the road.
Bank of America
YTD Return (adjusted for dividend and splits): -38.7%
BAC Preferred Series J 7.25% (BAC-PJ ) traded above its preference price of $25 per share earlier this year, but as financials suffered, it trended around $24-25 per share, even during the beginning of this month, but on Friday, the preferred shares dropped from around $23.75 to below $21.50 intra-day before closing at $22.69. This volatility is not normal at all and neither is the strong correlation of returns between the common and preferred. Still, the preferred's relative strength despite the common's steep sell-off is promising for the underlying faith in the bank's solvency.
YTD Return (adjusted for dividend and splits): -29.3%
Citigroup's Series F, 7.25% (C-PF) also traded above the $25 per share preference up until the beginning of August. But on Friday, the stock dropped from $25 to $23.50 before closing at $23.83. To put things in perspective, this preferred equity typically trades within a $0.10 to $0.20 daily range. This remained true even during the sell-off last Thursday. Investors should pay close attention to the activity in this and other Citigroup preferreds. An increased correlation with the common implies a rising bet on insolvency.
Goldman Sachs (NYSE:GS)
YTD Return (adjusted for dividend and splits): -25.2%
Goldman Sachs Series A 3.75% preferreds (GS-PA) yield around 4.57% at current prices. Like the other preferreds, they generally trade modest volume and trade volatility but in Thursday and Friday, the volatility increased meaningfully. The high-low intra-day range jumped from around $0.20 per day to between $0.80-$1.00 per day during the most recent sell-off.
JPMorgan Chase & Co (NYSE:JPM)
YTD Return (adjusted for dividend and splits): -10.2%
JPMorgan Series I preferreds showed some relative strength. The volatility in this issue also increased meaningfully over the last two days, but unlike the other preferreds, they finished much higher on the day. The shares opened at $27.15 and traded as low as $26.41 before closing at $27.50. Considering the strength in JPM's common, it is not surprising that the preferreds are also industry leaders.
Wells Fargo (NYSE:WFC)
YTD Return (adjusted for dividend and splits): -17.8%
Wells Fargo's Series J preferreds have traded in excess of $28, but from Thursday to Friday it traded as low as $26.40 before bouncing back to close at $27.25.
Common shareholders of major banks and financial companies have paid a price for their bullishness but despite the draw down, preferred securities in these same companies have signaled relative calm. Many have viewed the divergence between common and preferred equity performance as a sign of an oversold banking industry. We think there is credence to this thesis, but if the increased volatility among preferred securities carries over from last week, this could signal a massive change in financial market sentiment. And as the last crisis clearly illustrated, the financials are ultimately based on faith because all finance companies are leveraged and dependent on the willingness of lenders.
For investors looking for another sign of a change in sentiment, they should monitor the VIX Index through securities like iPath S&P500 VIX Short-Term Futures (NYSEARCA:VXX). During 2011, the index has drifted lower from 37.61 to 30.31, a -19.4% return, but the index spiked recently and could represent a turning point for the financial industry and broader market.
Disclosure: I am long BAC, C. If prices continue to drop, I could accumulate preferred or common shares of BAC, C, GS or WFC