U.S. Bank Stocks: Don't Fade The Tail Risk

Summary

• US bank stocks (KRE) have underperformed the S&P 500 by ~28% the last 12 months.
• Banks have preemptively increased their loan loss reserves, even though credit fundamentals have not yet deteriorated.
• Credit fundamentals will worsen due to poor economic fundamentals unless the government passes another stimulus package (and even then they still might worsen).
• The risk/reward proposition does not favor owning KRE at this juncture.

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US bank stocks (NYSEARCA:KRE) have underperformed the S&P 500 by ~28% the last 12 months.

source: Yahoo Finance

The market is pricing-in elevated solvency risks within the banking sector's loan books. Bank management teams generally agree with the market's risk assessment - the banks have nearly doubled their loan-loss provisions over the past 6 months.

source: FRED

Bank management teams are prepared for a material increase in charge-offs (loan defaults). Economic fundamentals are improving from their nadir earlier this year, but still imply massive credit distress at current levels. The following charts show 1. Consumer credit delinquency rates vs. unemployment, and 2. Commercial/Industrial delinquency rates vs. Industrial Production.

source: FRED

Credit fundamentals have diverged from economic fundamentals because of massive increases in government spending in 2q and 3q (by far the largest spending surge going back to 1960!). Loan programs like the PPP kept businesses afloat, and federal additions to unemployment benefits actually increased wages.

source: FRED

Historic government stimulus has buoyed commercial and individual credit. Congress is attempting to pass another (but smaller) stimulus bill ASAP. Widespread vaccine distribution is set to occur in April/May. Will economic life "return to normal" this summer without the Covid economic disruption resulting in any real credit distress? What are the potential scenarios and what do they mean for KRE (assuming widespread vaccine distribution in May)?

1. Congresses passes the proposed stimulus package, and then passes another meaningful stimulus package once Joe Biden takes office. If Dems can win both senate seats in Georgia and thus control the senate, the chances

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. I have no business relationship with any company whose stock is mentioned in this article.