Banks: Keep Them On The Avoid List - Here's Why

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Includes: C, FITB, KRE, SNV, SPY, WFC, XLF
by: Eric Basmajian
Summary

Banks, and regional banks more specifically, have underperformed dramatically over the past 18 months.

In an environment of decelerating growth and decelerating inflation, interest rates decline and the yield curve flattens, a bearish scenario for financials.

Using the economic cycle, an allocation to banks could have been avoided in favor of defensive sectors such as utilities that continue to massively outperform.

Banks: Keep Them On The Avoid List - Here's Why

Bank stocks continue to underperform the broader market which is at odds with what some are calling the "greatest economy ever." Bank stocks were sold to the investing public as a great investment due to the massive capital return programs, endless buybacks, deregulation and the inevitable rise in interest rates. Despite these perceived tailwinds, bank stocks have been one of the worst equity market sectors, declining on average while the broader market and defensive sectors more specifically continue to soar to new highs.

Were you sucked into bank stocks based on some of these narratives? These arguments were convincing to those who do not use the economic cycle to guide their investment decisions which is often the biggest and most dangerous mistake to make.

Let's take a look at the past thesis behind bank stocks and the forward outlook through the context of the economic cycle to understand why bank stocks should have been avoided in favor of rapidly rising defensive positions such as Treasury bonds and utilities, and why they should likely continue to remain on your avoid list.

We started to make the negative call on bank stocks in May of 2018 in a series of articles starting with one titled, "How To Play The End In The Bank Rally", due to the outlook and forecast for a deceleration in the rate of economic growth, or more simply, the economic cycle.

Since that note in May of 2018, in which we actually initiated a short position in Regional Bank ETF (KRE), a position we still hold today, KRE has declined by over 15%.

This massive decline is relative to a gain of 12% for the (SPY) ETF and a gain of 23% for utility ETF (XLU), a long position recommended in the same note.

Using the economic cycle, in the way that will be described below, allowed for positioning away from bank stocks and into the most hated utility sector, a spread that has yielded a nearly 40% performance divergence.

Let's see how the economic cycle can guide our investment outlook.

In a recent note on why cycles matter, which you can read by clicking here, I highlighted seven "up cycles" and seven "down cycles," the seventh which we are currently still in as outlined by the data below.

The cycles, defined using the IHS Markit Global PMI and several factors such as the length of the decline, the magnitude of the decline and the breadth of the decline are outlined in the chart below. Down cycles are from points A to B and up cycles are from points B to A.

Global Cycles:

Source: Bloomberg, EPB Macro Research

We can test the performance of various assets as we did in the previous research note during each up cycle and each down cycle. The results are overwhelmingly clear.

During up cycles, or when growth is accelerating, financial stocks rise nearly 30% on average, exceeding the average return of the S&P 500 during the same up cycles.

During down cycles, however, financial stocks decline roughly 12%, nearly doubling the loss of the broader market during down cycles.

While the results are very clear, they are not all that surprising.

When the economy is accelerating, interest rates generally rise, banks can make more profitable loans and the stocks of various bank companies rise in value.

Conversely, during declines in the rate of growth, accompanied by lower interest rates and a flatter yield curve, bank stocks decline and underperform the broader market.

Cycle Returns: Financials

Source: Bloomberg, EPB Macro Research

Now there is a common argument that surfaces whenever discussing decelerations in growth. Many are suggesting we are not in a down cycle because the stock market is rising and the job market is "solid."

Firstly, the term "solid" is a subjective description. The rate of job growth is at an 18 month low.

Moreover, many confuse decelerations in the rate of growth with recessions. A recession is a contraction or a negative rate of growth spread across many sectors of the economy while a deceleration in the rate of growth is simply a decline from 3% growth to 1% growth, as an example.

These accelerations and decelerations in growth within a business cycle, which last roughly 18 months on average, drive nearly 100% of your investment returns over time.

This current slowdown in growth can be easily identified by the ISM manufacturing PMI which has fallen to a 35-month low.

ISM Manufacturing PMI - 35 Month Low:

Source: Bloomberg, EPB Macro Research

The other common objection is that manufacturing is not as important as services. While this can be debated as far as a leading sector of the economy, the point is moot because the ISM services index has also declined to a 35-month low, highlighting this current economic slowdown is broad-based and fairly pervasive.

While this data does not in any way imply a recession, it is empirically observable and undeniable that the rate of growth in nearly all sectors is declining.

ISM Services PMI - 35 Month Low:

Source: Bloomberg, EPB Macro Research

After conceding that growth is slowing, many investors remain unconvinced of the implications to their portfolio which is understandable. As noted in the second chart, however, the data clearly showed a massive 30% return for bank stocks when growth was accelerating and a harsh 12% decline for bank stocks during growth decelerations as we are in today. Since January 2018, the bank index is down over 8%, perfectly in line with the historical results.

Regional banks, the sector that we actually initiated a short position in, while the history is limited, shows an average gain in excess of 30% during up cycles and a loss of nearly 16% during down cycles.

Regional banks, more cyclical and more sensitive to interest rates, have results that are magnified in both up cycles and down cycles.

Cycle Returns: Regional Banks

Source: Bloomberg, EPB Macro Research

It is clear that bank stocks are not a safe investment during down cycles, an environment in which we currently live.

While outlining the bear case for bank stocks over 14 months ago, and reiterating the thesis several times in subsequent notes, many common objections surfaced.

The biggest rebuttal came in the form of buybacks. Banks have been massive repurchasers of their own stock in recent years, to the point were several large banks reduced their share count 10% year over year.

Who would want to stand in front of a 10% reduction in shares in just one year?

The historical research suggested that the economic cycle was the more powerful force, as it is virtually all the time, and despite the massive buyback programs, bank stocks have still declined.

Wells Fargo (WFC) repurchased 9% of their shares in one year with limited help to the share price.

Buybacks Aren't Helping:

Source: Company Filings

Citigroup (C) is another large bank that repurchased 10% of the float in just one year.

Buybacks Aren't Helping:

Source: Company Filings

When we look at the performance of these companies since the turn of the economic cycle, they have both declined despite the record buybacks. WFC is down more than 26% and C has declined 13% since the cyclical inflection point in growth.

Buybacks Aren't Helping:

Source: Bloomberg

It is fair to point out that WFC is in the penalty box for various reasons but the entire bank index (XLF) and regional bank index (KRE) are both down over the same time period in the face of similar buyback stories.

Digging into the KRE ETF, we can look at three top holdings and test the cyclical performance as we did above.

Synovus Financial Corp (SNV) historically has gained more than 15% during up cycles and has declined an average of 8% during down cycles.

Why fight the cycle when the results are clear? It is much easier, more profitable and less stressful to overweight sectors that perform well during economic decelerations.

Cycle Returns: Synovus Financial Corp (SNV)

Source: Bloomberg, EPB Macro Research

Regions Financial, another top holding in ETF KRE, rises an average 30% during up cycles and declines a sharp 17% on average during down cycles.

Cycle Returns: Regions Financial Corp (RF)

Source: Bloomberg, EPB Macro Research

Popular regional bank Fifth Third Bancorp shows similar results with an average increase of 36% during up cycles and a decline in excess of 20% during down cycles.

Cycle Returns: Fifth Third Bancorp (FITB)

Source: Bloomberg, EPB Macro Research

A significant factor behind the performance of bank stocks during different phases of the economic cycle is related to interest rates.

The 10-year Treasury rate virtually always rises during up cycles and nearly always declines during down cycles.

Many investors in financial stocks have made the investment on the basis of rising interest rates when that is just another example of fighting the economic cycle.

Cycle Returns: 10-Year Treasury Rate

Source: Bloomberg, EPB Macro Research

The data presented above simply demonstrates how important the economic cycle is in your investment decisions. The direction of the economic cycle is responsible for virtually all the change in broad sector and asset classes over 12-18 month time periods.

If you understand the direction of the economic cycle, you have the highest probability of allocating to the correct sectors and asset classes.

The data is so clear that after conceding the point that cycles are the most important factor across your entire investing career, the logical objection revolves around an inability or a lack of belief that cyclical turning points can be forecast with any degree of accuracy.

The good news is that we are not timing the markets but rather the predictable rhythm of the economic cycle which you can undoubtedly forecast.

Forecasting economic inflection points can be done by monitoring baskets of economic data that both logically lead in the economic sequence and have empirically led the economic cycle throughout history.

At EPB Macro Research, in addition to studying secular economic trends and business cycle trends, we are hyper-focused on the short-term growth rate cycle or the 12-36 month fluctuations in growth that drive the majority of your investing returns.

When analyzing these shorter-term cycles, we use a combination/confirmation process of several leading indicators, separated into two baskets: longer leading data and shorter leading data.

Longer leading data turns as much as 12-18 months before cycle turning points, followed by shorter leading data with moves that can be 6-8 months before downturns and 3-4 months prior to upturns.

By measuring long leading data, and having it confirmed by short-leading data, a high level of conviction can be gained before a cycle turning point and a pivot in asset allocation.

The long leading indicator graphed below, one of several long leads we use, outlined this current down cycle over 12 months in advance of its inflection point.

Long Leading Index Vs. Global PMI:

Source: Bloomberg, EPB Macro Research

After the long leading indicator has inflected, we then start to get hyper-focused on a variety of shorter leading indicators that turn next in the sequence.

Below is a shorter leading index of the US ISM manufacturing PMI.

As both charts show, without a sufficient upturn in either the long leading indexes and without confirmation in shorter leading data, the call for this economic "down cycle" remains and the allocation to defensive sectors over cyclical sectors and bonds over stocks remains firmly intact.

This is the primary reason why bank stocks, and specifically regional bank stocks, should remain on your avoid list. You are still fighting the economic cycle.

ISM PMI Leading Index:

Source: Bloomberg, EPB Macro Research

Once both long leading economic data inflects higher, which is then confirmed by an inflection in shorter leading data, the negative outlook on bank stocks will start to ease and flip positively.

Cycles are critical. You may be invested in a sector that is a land mine without knowing it and this is where the problem lies - not being a few weeks late to the turning point.

Following the turning points in the economic cycle could have yielded massive outperformance in utility stocks over bank stocks, a trade outlined over a year ago in the May 2018 note.

Actionable Idea:

LONG XLU

SHORT KRE

I am recommending a spread trade: long XLU and short KRE with the performance coming from the difference in the total return performance.

The time frame for this trade is 12-18 months which will prove to be enough time for both the effects the slowdown to impact bank profitability as well as the negative impacts from Federal Reserve tightening and yield curve compression to appear.

- May 2018 | How To Play The End In The Bank Rally

Utilities Vs. Banks - Massive Outperformance:

Source: Bloomberg, EPB Macro Research

The easiest way to use the leading indicator process is to be long of cyclical equities during up cycles and shift to overweight bonds and defensive equities during down cycles. It also makes logical sense and can be done in both tactical accounts and your more long-only passive accounts. Aggressive during up cycles and defensive during down cycles.

Knowing the direction of the economic cycle is the best way to maximize your upside and minimize your downside risk. The biggest risk to your portfolio always happens when you are on the wrong side of the cycle.

Until we have a sufficient turn in the economic cycle, bank stocks will have an uphill battle and should likely remain on your avoid list for the time being. When the cycle turns and growth inflects higher, bank stocks will be a great investment, likely outperforming the S&P 500.

Disclosure: I am/we are long XLU, SPY (UNDERWEIGHT ALLOCATION). 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.

Additional disclosure: Short KRE

I am long Treasury bonds across the curve.