Financials Are Painting A Dire Warning Sign For The Market

Summary

• Financials are suggesting that trouble lies ahead for the stock market.
• The root of this problem stems from yields that are on the cusp of a decline.
• Meanwhile, stocks are already overvalued.
• Looking for a helping hand in the market? Members of Reading The Markets get exclusive ideas and guidance to navigate any climate. Get started today »

The bond market and the financial stocks may be sending a dire warning sign for the stock market. For the most part, it seems investors are missing out on the signals that are being sent. If the warning signs prove to be correct, it could suggest a market reversal is now in the works.

The S&P 500 has been range-bound since April 9, trading in a range between 2,800 to 2,900. But earnings estimates have been deteriorating and pushing the valuation of the index to very overvalued levels on both current year and one-year forward earnings multiples.

Banks Are Issuing A Dire Warning

But the most worrisome region one should focus on is the signals sent from financial stocks. The financial ETF (XLF) has what could be a very bearish technical pattern forming a double top. For this pattern to be confirmed, the ETF would need to fall below $21.10. If that happens, we could see the ETF fall first to $19.80, and as far as the March lows.

Treasury Yields On The Brink

One reason why bank stocks may be suffering is that the economic outlook for the US is fragile. Interest rates on the 10-year yield tell us just how weak the economy is, trading at roughly 70 basis points.

More concerning is that bearish technical pattern that has formed for the 10-year Treasury yield, a descending triangle. This pattern suggests that the yields on the 10-year could fall below 50 basis points soon.

Negative Rates

Even more amazing Fed Fund Futures for March 2021 are now pricing in negative Fed Funds Rate, trading as low as negative 0.05% on May 7. Meanwhile, the 2-year is making a new all-time low around 14 basis points.

The weak trends in bond yields and banks go hand in hand since the banks make a good portion of their revenue from loans and interest income. Therefore, the lower rates fall, the lower the interest income falls. Additionally, during a period of an economic recovery, banks stock would tend to lead to a comeback, since they would benefit the most from rates rising and loan growth. At this point, the banks and Treasuries are suggesting that the economic outlook may still get worse before it gets better.

Banks Estimates Have Been Slashed

Banks such as JPMorgan (JPM), Bank of America (BAC), and Citigroup (C) have seen their earnings and revenue estimates cut dramatically for this year and next. These estimates revision play right into and support the thesis that banks stocks reflect an abysmal economic outlook.

Getting Worse

There is no denying that the economy is not in good shape, especially after a horrible first quarter. The second quarter is projected to be even worse, with the Atlanta Fed's GDPNow tracking a second quarter decline at an annualized 17.6%, a jaw-dropping number. Additionally, analysts are forecasting that 21.5 million jobs had been lost in April, while the unemployment rates may rise to 16.4%, when the report comes on May 8.

If the bond market and the financial sector are both reflecting the economy accurately, and what may be to come, then it might also be a sign that the S&P 500 itself is long overdue for a pullback.

Earnings Estimates Still Plunging

Although stocks have been range-bound since the middle of April, the earnings estimates have dropped dramatically. That is helping to make the S&P 500 more overvalued today than in February. I have created my own earnings model for the S&P 500 using bottom-up aggregate earnings estimates for the S&P 500. Based on my latest model, I am forecasting the S&P 500 to earn $123.83 in 2020 and $159.28 in 2021. In 2019, the S&P 500 earned just over $157 per share. It indicates that the S&P 500 will have no earnings growth for the next two years. It leaves the index trading at 23 and 17.9 times earnings estimates.

Historically, the S&P 500 has traded for roughly 16 to 18 times one-year forward earnings estimates. Based on those trends, the S&P 500 is likely worth somewhere between 2,550 to 2,865. The S&P 500 as of May 7 is trading for 2,882. Should those earnings estimates continue to trend lower, it will just push that valuation range lower. Additionally, one could argue that in such an uncertain economic environment, the index should trade with a valuation range of 16 to 17, shrinking the S&P 500 value to 2,550 to 2,700, and the potential to drop by as much 11%.

Risks

Should bank stocks break down and follow Treasury yields lower, it could send a very dire warning sign about the health of the US economy, and to the stock market. While nothing is guaranteed, should the highly-anticipated jobs report come in better than feared, it could quickly get investors to be more bullish on the economic outlook, sending interest rates higher and bank stocks up. It is, of course, always a possibility. Should that happen, rates on the 10-year could quickly begin to approach 1%, while the Financial ETF return to recent highs.

With the economic outlook uncertain and the stock market now in an overvalued state, it seems that the risk for the market is for lower prices and not higher prices. If the bond market and the bank stocks are suggesting the economic outlook worsens, then the stock market may be in for a harsh dose of reality.

Analyst’s Disclosure: I/we 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.

Mott Capital Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Upon request, the advisor will provide a list of all recommendations made during the past twelve months. Past performance is not indicative of future results.

Comments

[Bling777]

If this was a free market, meaning a FED-free market, the XLF probably would roll over. The market would be nowhere near current levels either, of course. But with current circumstances I have to believe that a small dip would be a good entry point to get long the XLF. Just seems like at some point money may rotate out of stuff that has gone up a ton, and that would be a likely place to catch a bid... just because the market rally is not being driven by fundamentals.

I would not buy with abandon or without risk management either with position size or stop losses, but until proven otherwise, seems wise to buy the dip on just about anything. If you can't beat 'em, join 'em.

[stbradshaw]

Good summary and article, but like the GFC Fed/central banks ability to print gives investors ability to buy the dip and hope for the continuous outperformance, surprisingly data showing that Institutional investors (are underweight/cautious) and its retail mostly doing the deployment of capital, tough to see if this may change?

[EliasMouawad]

@stbradshaw Institutional investors matter more than retail investors. Especially in the case of large cap high quality companies. That's why i am confident SPG will recover.

[Sleepless@FED]

Cannot/Can service their loans

[Sleepless@FED]

Fixed costs of operating a bank are -
Real estate rent
Utilities
Staff salaries
IT infrastructure
They can reduce this by closing branches. Banks are financial intermediaries between people who save & people who borrow. If not enough people that borrow cannot service their loans - pay interest on time or repay debt on schedule, banks make a provision for doubtful debt. Due to covid, there will be more borrowings as employers have to pay for their fixed costs with uncertain prospects of future revenue. Banks will face huge write offs and deplete their capital/reserves if this lockdown prolongs for 4 more weeks or if we are forced to lockdown again in fall. There is a lot of uncertainty on future earnings. Uncertainty should result in a sell off but FED is intervening and it’s an election year - also they don’t want the “wealth effect” from stock market on household to start fading...when they can control it with paper money & no inflation. Let’s all hope that a vaccine is found soon. Any relapse of covid would kill this market in ways we never saw before. Countries like Russia, India, Brazil (BRIC) are seeing their covid cases accelerate now...not good...Consumption has gone for a toss...

[Intl Investment Services]

The markets, including the financial institutions the article described, had been dysfunctioning since this president and this Fed believe that more money can pump up the stock market and employment will come next. That's where the disconnection is between the market and economy. But even if the markets hit new all-time high again with 20 million+ no jobs, you would think these monetary policies are working for most of the people? Definitely some people would be benefiting from extra $2T. The question is, WHO?

[dogety]

Why limit to only 'this President and this Fed'? This has been going on for decades - we've never looked back to assess the damage - we've always looked ahead at what else we could do. It is far more the fault of the people (me included) than the government. They, the government, are a microcosm of us, nothing more - nothing less. We have always said - the budget is far to high trim the 'fat' - but don't cut from ME - or mine!

'Know when to hold 'em, know when to fold 'em, know when to walk away, know when to run...,' - thank you Kenny and RIP!

[Donggle]

@Intl Investment Service @dogety If you do not know history it is bound to repeat itself or one thinks everything is new.

The blame for the Great Depression lies firmly with the failures of the Federal Reserve. This is a blame not only because the Fed did not take counter measures to forestall the economic decline but also that the Fed's actions precipitated the decline in the money supply.

Once the Depression was developed the money supply was increased but that did not end the Depression. Once a balloon is punctured it is not easy to re-inflate it.
www.thebalance.com/...

Seems like the FED is doing the right thing.

[terryongarland]

@Intl Investment Services ....disconnection is between the market and economy. I disagree. The market knows todays fundamentals suck. The market is forward looking 6 months. The articles have been in abundance pro and con. Mr market acts in what is believed as their best interest..with skin in the game. You may disagree , but do you have an all cash view or are you shorting ?

[SilentRage]

For the first time in its short but eventful history, Bitcoin has much more clarity on its future outlook than a dislocated stock market. BTC at least has stronger than ever fundamentals (unprecedented fiat currency prinitng and debasement), while the stock market's only hope in its cloudy future is that the Fed keeps its asset-inflating policies intact forever.

[Donggle]

@SilentSage why do I need a crash seems like every six months?

[SilentRage]

There's nothing I hate more than paying up to buy stocks so I don't miss out on the next leg up. I feel so much better trying to catch a falling knife than chasing an asset bubble.

[dogety]

Well it does have something in common with our government / budget - it also is unsupported by reality.

[user50295553]

Mike,

I see this as one of the most sensible articles I've seen recently. I have been investing since 1969 and nothing has come close to the current situation. Even the reading I have done on the Great Depression was without the threat to the millions affected by it.

I see it as a unique and therefore, unknowable outcome.

[Donggle]

@Dino5225 The blame for the Great Depression lies firmly with the failures of the Federal Reserve. This is a blame not only because the Fed did not take counter measures to forestall the economic decline but also that the Fed's actions precipitated the decline in the money supply.

Once the Depression was developed the money supply was increased but that did not end the Depression. Once a balloon is punctured it is not easy to re-inflate it.

The Fed learned its lesson, now we will see if the out come will be different.
I'm betting on Financial Engineering. Of course we have no choice but to go along for the ride. So far it feels good.

[user50295553]

Donggle,

"I'm betting on Financial Engineering."
Well, looks like history may be on your side.

I believe blame for the Great Depression lies with the wealthiest stock manipulators of that day who used the precursor to the internet (phones) to simply organize a run-up in any given stock and then, called the other guys when they all had a good gain and coordinated a …"SELL".

Pity the poor shoe shine boy.

The most recent market peak followed another manipulation headed by Goldman Sachs guys, Robert Rubin (who got rid of the Glass-Steagall Act—allowing AAA rating of crap mortgages) and Henry Paulson.

Both became Secretaries of Treasury and held rates artificially low. Bernanke, as head of the Fed, then provided low rate borrowing and the big guys all did large stock buybacks—kiting prices. Too-big-to-fail banks went from 32 to four. tiny.cc/vomm9y

Corporate stock buybacks had been prohibited from 1934 until 1986.

Recently the Fed acted is spite of previously forbidden behavior and bought high yield (junk) bonds. Hmmm, Mnuchin, another Goldman alum just happens to be Treasury Secretary.

Shades of the Great Depression setup.

[AAA Investments - PayONLY4Performance]

Dino,

“Shades of the Great Depression setup.”

Not to mention the velocity of the Feb./Mar. drop echoed of the GD AND the rate of unemployment...

Yes, the market is a forward-looking beast, but it’s looking more and more like it’s 6-12 Mo. view is absolutely priced to perfection

zero room for earnings misses, policy snafus, political uncertainty, hair-raising tweets (will ramp up after the election regardless of outcome)

[solar_master]

Our Covid response isn't going well folks. The Federal government is out of lunch. Do not kid yourselves.

There are no bright spots here. We should be doing this together as a country, there should be a national strategy. Not this 50 state free for all – different rules, different numbers, back-biting and overpaying for equipment, mucked up to the brim with politics.

The governors following science and staying above politics are being praised and getting solid approvals. The White House task force is now a running joke for all of history.

I suppose the stock market is holding up because of all the socialist money pumped in by all the "free market tigers" running the show from the Oval Office. But it won't last.

Just wait until the next wave comes. Good luck, we're going to need it...

[smithtrainashworth-lord]

Hello Joe,
I live in the UK and I think most people here would agree with everything you are saying. It is the democratic right of each country to deal with the pandemic as it wishes, but many people here view what is happening in the US with horror.

[RickJensen]

Just more TDS.

[solar_master]

Yeah Ricky, I have TDS - Trump(S) Deficit Syndrome.

I get crazier and crazier as this year's deficit (now $3.8 trillion +) grows another trillion with no end in site.

I caught the part about him signing the checks, I missed the part about how we're paying for them.

Socialism I guess.

[Illius]

Overly simplistic view of things. This isn't even Economics 100.

[EliasMouawad]

@Illius Bears have been scandalously wrong for the past 45 days.

[Sam In LA]

@EliasMouawad

You're not wrong.

But if we are still in a bear market, 45 days is too short a time frame to call the game as over. Unless this turns out to be the shortest bear market in history (and I'm not clairvoyant), we're probably still in the first or second inning.

[dogety]

As have politicians and our 'experts' - at whatever.. Make statements about what is to happen and the after effects of whatever programs are in force - then never held accountable for what they have said

[bvandersall]

Promise?

[User 51352630]

Think I would like to puke if I see one more article of Gloom and Doom. Some things are working. Stock pickers market to keep working until one finds out which ones are working. Worked the 26 day rally when all said run and keep running. Sold down now starting buying back Monday. No one cannot time this market or really any market but when you get lucky that what it is luck. No money made in cash.

[Illius]

What is working for a while is the $4 Trillion of fresh dollaros dumped into the market by a crazed leadership that is clueless on all fronts. Of course a lions share of that seeps into the market. But the underlying growth is negative and this triage will only work for a quarter or two. trump is desperate for reelction because he knows he is facing countless indictments in the NY district the day after Biden is inaugurated. I am sure they'll try another infusion. But look out below when 2021 rolls around and the bills have to be paid. BTW..did you know that the ascernable debt ratio of Japan is 3???? We will probably end up there very soon.

trump could well go down in history as the American Nero, the man who
destroyed the USA.

[AlmostEven]

Money saved is money made

[Tompatnic]

I see that liberal trolls have taken over this website also. First, the revelations of the last two days on Flynn and the Russian hoax ill render any NY state investigations baseless. The current actions are no different than TARP and the S and L bailout. The blue state governors wanted to make their own decisions and the current deficits and unemployment are on them

[YeaJust]

If you missed a buying opportunity then you missed it. Stack your cash for the next dip even if it’s in 2-5 years. As a millennial I have already experienced two huge economic downturns in my adult life + 1 during high school. That’s three over a 20 year period... plenty of opportunity to make money...

[bong70]

ah a millennial i want to thank you guys for driving market back up...

[User 50085325]

Financials, maybe more than any other sector, signal recessions. Stocks historically bottom - on average - 70% of the way through a recession. However, the trough has come as early as halfway through recessions that were short and sharp. With that said, the average US recession has lasted 22 months. But, the shortest recessions since the mid 1940's, lasted only six months, from January to July 1980. Most Economist who study recessions are sending a mixed message about the outcome of a Pandemic driven recession. Some even say that we may have been in a recession prior to the Pandemic. IDK .. So for arguments sake, let's work off 2/2020 and do the math. Twenty two months is - 12/2021. Taking the average historic bottom for stocks of 70% of the way through a recession and your looking at a timeline leading to 15 months or 6/2021 with a best case scenario of 50% of the way through being 1/2021.

[bulzap]

Your math is wrong. If you say 22 months then it is 12/2021 not 12/2023.

[User 50085325]

@bulzap - you are correct my friend .. and there is lesson to be learned here. Never drink and text :)

[Benitez]

Stop saying that the market is overvaluated is not true. Nasdaq have recovered its value because biggest technological companies have not been affected by the covid-19. some of them such as AMZN and MSFT have increased their value during this period. The Dow
, instead is ...down.. jjejej, 16 % so it is not overvaluated either.

[Oakwest Corp - Canada]

FB revenue is 98% ads and 30-40% of those are from travel related companies and restaurants. Google revenue is over 84% ads. Amazon relies on consumer spending and there are 33M who have lost jobs, will they all get them back? I doubt it.

Tech is for sure the winner in all this. But to say the biggest tech companies haven't been affected is silly.

I did not sell anything during selloff and bought all the way down and have done well, not perfect. Would have deployed all dry powder if I thought there would be a rally like this of course. We will see but have been raising cash in anticipation of a retest of lows.

Good luck to all

[AAA Investments - PayONLY4Performance]

jap,

“Stop saying that the market is overvaluated is not true.”

Wow, really...you must either be drinking or smoking some GREAT hopium (please pass it around and don’t be so selfish)

Unfortunately, your OPINION, is contradicted by pretty much EVERY valuation-ratio tied to the market.  

In FACT, most of the ratios are more extreme now than before the C-19 outbreak...to the tune of Great Depression, dotcom, or GFC depending on the metric.

GLTY...you’re going to need it

#JimJonesSaysThankYou!!

[bong70]

the markets are running out of oxygen they are so high... people keep saying bears are wrong no they have been given an opportunity of a life time... permabear's would of caught the drop but average joe shorter not so this rally has provided a great chance to have another bite at the cherry for the retail shorter.. remember free markets will have to return soon and true price discovery will be found good luck all..

[Iron Donut]

I buy stocks like I'm buying a fractional share of a business then I hold that fraction of business ownership and take part in the underlying cash flow over the course of years. I've held fractional ownership in some companies for 15+ years.

When I read technical analysis articles aimed at traders it may as well be written in Russian. I don't understand a word of it.

We are completely different animals playing in the same sandbox.

[katmandu100]

Excellent data and commentary,thanks.

[Slade_01]

Nah, no problem.
Financials haven't had a real double top since 2007-8, and look how well that turned out. ;)

[Aby273]

"Should bank stocks break down and follow Treasury yields lower, it could send a very dire warning sign about the health of the US economy, and to the stock market. While nothing is guaranteed, should the highly-anticipated jobs report come in better than feared, it could quickly get investors to be more bullish on the economic outlook, sending interest rates higher and bank stocks up. It is, of course, always a possibility. Should that happen, rates on the 10-year could quickly begin to approach 1%, while the Financial ETF return to recent highs."

Can we sum this up in 1 line?

I have no goddamn clue; any positive/negative signal can take us anywhere!

[texasinvest]

Value is a bet on America. That is why Buffet "lost his touch". Growth is a bet on dystopia and is crushing it.

[Kyle Fishman]

Another day, another prediction.

On April 7th you said this rally can't be trusted.
seekingalpha.com/...
Well you should've trusted it because it went higher since that time.

[User 51502809]

If you change your investments every week or two, you're not really in the investor category. You're in the day trader or at best technical analysis camp.