Either Banks Are Cheap... Or The Market's Gonna Crash

Large cap financials have had an awful time in the last month and are 11.7% lower so far in 2016.

As ConvergEx's Nick Colas details, that’s worse than pretty much anything else, including all other S&P 500 sectors, the Russell 2000 small cap index, and even the MSCI Emerging Markets Index. 

This down and out sector is worth a look for three reasons. First, it seems clear now that the investment case for the Financials, based on a series of Fed rate increases and a steeper yield curve, was either wrong or early.  Which is the same thing as wrong.  Second, volatility in the group (both actual and implied) is now equal to the levels of August-September 2015. Third, even if the largest banks, brokers and regionals merely meet the lowest earnings expectations on the Street, they are still only trading for 10-12x this year’s EPS and 9.5-11.0x next year.

 

One caveat, though, and it’s a big one.  If the stock prices for these largest financial institutions are right, then the broader market is clearly still overpriced.  Something has to give.

Ask any veteran stock analyst what industry group draws the smartest but quirkiest colleagues, and you’ll probably hear one sector more than any other: “Insurance”.  At my first job in a bulge bracket research department, the fellow who covered the space was fond of talking to himself at the oddest times and modulating his voice between a whisper and scream on the morning call. It was like being at a Joe Cocker concert, if Joe had a collection of Hermes ties. He would preface his talks with “I have three things to say”, and call them out as “#1”, “B”, and “Thirdly”. None of this seemed to hurt his franchise; he was regularly listed among the top 3 analysts following the sector, besting a score or more of worthy competitors.

I could list other examples of similarly quirky people drawn to the group, and over the years I have come to the conclusion that since the Insurance industry is virtually unanalyzable it breeds a certain genius-level eccentricity in those charged with making sense of it.  And just behind them are the bank analysts. There’s more of these in the wild, looking at everything from small regional banks to the largest household “Money center” names.  And since the start of the year, they have generally been a miserable lot.

The Financials component of the S&P 500 is down 11.7% year to date.  To put that in perspective, this performance is worse than:

Any other major S&P sector, including Energy which is actually outperforming the broad market by 140 basis points thus far in 2016.

 

Any other broad market index, including the S&P Mid Cap 400 (down 7.0%), the S&P 600 Small Caps (down 8.1%), and the Russell 2000 small caps (down 10.8%).

 

The two major international stock market indices – the MSCI EAFE developed market (down 7.1%) and the MSCI Emerging Markets (down 6.4%).

When you see this kind of “Pain trade” in capital markets, you know two things.

There is a lot of aggressive selling. We saw that today with mega-cap banks such as Bank of America, Citigroup and Wells Fargo all moving through to new lows intraday or at the close.

 

There is fear in the air. Look at both the Implied Volatility and actual 30 day Historical “Vol” for the Financials sector of the S&P 500. Both hover around 25%, the same level the group saw on average from late August to September 2015 during the last market meltdown.

Since contrarian thinking is one of the hallmarks of both good investing and sharp trading, the logical question is “Does the market have it right, or is the current price action an overreaction?”  To evaluate that, you have to understand why so many market participants got the Financials so wrong in this still-young year.  A thumbnail sketch of the problem:

Interest rates. At the beginning of the year the consensus opinion was that the U.S. yield curve would slowly steepen over time.  We were just coming off a December Fed meeting where the central bank finally raised short term rates. Ten year Treasuries yielded 2.25% and should have been on their way to 2.5%. Market sentiment is that a steeper yield curve makes for a better profit environment for the banks.  Fast forward to today and the yield curve is flattening like a soufflé after a solid rap. And confidence in rising bank earnings has flattened as well.  It also doesn’t help that trillions of dollars’ worth of overseas sovereign debt trades for increasingly negative interest rates…

 

Concerns over oil-patch credits. The decline in oil prices to largely unforecasted levels makes for a large question mark over all the lending done to support the industry during boom times.  And while most U.S. banks have taken pains to quantify the limited nature of their particular exposures, the market clearly isn’t picking up what they are putting down.

 

U.S./Global economic growth. Fourth quarter U.S. GDP was barely positive at 0.7%. A strong dollar (until today, anyway) has put a crimp in confidence over U.S. corporate profits.  Reported unemployment is low enough that further job gains will be slower than prior years.  Overseas economies are sluggish and central banks in Japan and Europe now sit with negative overnight rates that look to get even more negative as the year goes on.  None of this is good for a traditionally “Early cycle” group like the financials.

So are the U.S. large cap financials cheap enough to buy?  To answer that question, we did a simple analysis of the ten largest “Money center” banks and the ten largest regional institutions.  We looked at their current price and analysts’ earnings estimates to determine their forward P/E ratios for 2016 and 2017. Our one wrinkle on this traditional analysis: we also pulled the single lowest earnings estimate for each name.  It is our “What’s the worst that can happen” scenario.

Here is what the math means for Financials valuations generally:

The larger institutions (mostly multinational banks and brokers) trade for 9.6x/8.7x the mean analyst earnings estimates for 2016/2017. In a world where 10x forward earnings puts a name or group within range of typical “Value” investors, this looks cheap.

 

Looking at the worst-case-scenario estimate for each name, the average P/E ratio goes to 10.4x and 9.5x for 2016 and 2017. Still below that 10x threshold, in other words. And therefore still statistically “Cheap”.

 

The large regional banks trade for 11.4x and 10.0x this year and next year’s mean earnings per share estimates. A little more expensive than the “Money center”, but one can hardly call these multiples expensive.

 

For the worst-case-scenario estimates in the regional bank space, the multiples rise to 12.1x this year and 10.9x next year. Not as cheap as the larger banks, but (again) not out of bounds for a value oriented money manager.

Good investors know that you never buy stocks on just a valuation argument.  Any attractively priced investment can still find its way to an even more subterranean bargain basement.  The point of our quick analysis is simply to show that markets are pricing in what amounts to the most bearish take on Financials earnings power over the next 24 months.

In the end, the weakness in Financials so far in 2016 isn’t really about how much banks and brokers will earn in the next 2 years.  It is about whether or not the world’s major economies are slipping into a yet invisible recession.  If you could guarantee that the low estimates for bank/broker earnings would materialize, the group would rally from here.  The fact that they remain under pressure means there is a larger game afoot.

Simply put, either large cap Financials are cheap, or the entire U.S. equity market is still overpriced.  Their precipitous decline year to date means markets fear they are both the transmission mechanism for a global slowdown/recession to come and a primary victim of that event.  Or, from the glass-half-full side, they overly discount a bearish scenario that will not materialize. Short term, they should bounce since their recent volatility looks to be in line with prior spikes and near term bottoms. Longer term, global and domestic economies need to show some resilience. And the sooner the better.

Because, as Gavekal Capital exposes, banks are approaching relative performance lows...

The KBW Bank Index, which consists of 24 banks, is approaching 2008 and 2011 lows relative to the S&P 500. In the chart below, we plot the KBW Index against the S&P 500 going back to September 1992 which is when the KBW Bank Index began. We have indexed the chart at 100 starting in September 1992. Banks have underperformed the S&P 500 by nearly 37% since 1992 and only twice, in 2008 and 2011, have banks underperformed more. In 2008, banks had underperformed by nearly 48% and in 2011 banks had underperformed by about 43%.

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It’s not just banks in the United States that have been getting pummeled either. Not a single stock in our GKCI DM Banks Index is trading above its 200-day moving average.

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The median developed world bank is down 20% over the past year...

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And 85% of developed world banks made a new 200-day low on January 20th.

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This was a greater percentage of bank stocks that made a new low in either 2008 or 2011.