DataTrekResearch's Nick Colas notes this morning that:
" US large cap Financials trade like death itself. Looking at the weighting of this sector in the S&P 500, they should be nearing a bottom. At a current weight of 12.5%, they are back to trading at their June 2000 low"
And eyeballing the charts, he is absolutely not wrong...
The problem, Colas points out, is that markets may be pricing in something worse than a garden-variety slowdown and the February 2009 low weight was 9.7%, implying, this group needs to stabilize soon, or “the end is nigh” crowd will have one more arrow in their quiver."
In fact, as Colas details details, Large cap Financials are the only reason the S&P 500 is down for the year to date. Not Tech (still up 2.5%). Not Consumer Discretionary (+4.9%). And those two sectors’ returns are enough to offset declines in lesser-weighted sectors like Industrials (-10.4%), Materials (-14.3%) and Energy (-12.7%).
Here is the math:
- Financials are 13.1% of the S&P 500 and the group is down 12.5% YTD.
- The group’s average weighting in 2018 is closer to 14%, so that YTD decline is worth 175 basis points of drag to the S&P 500 (12.5% times 14.0%).
- The S&P 500 is 1.4% lower in 2018, but without Financials its YTD performance would be +0.4% (1.4% plus the 1.8% from the prior bullet).
We’ve covered two reasons for the recent weakness in Financials in these notes (end-of-cycle loan growth data and a flattening yield curve) but we want to add one more today: pronounced weakness in European banks.Three points to consider:
- The MSCI European Financials Index is down 26% YTD. Most of that decline has come since October, with the group off 18% from late September through today.
- After shrugging off the first part of this meltdown, US Financials are now catching up quickly. The 30-day correlation between American and European Financials is now 0.76; it was lower than 0.50 in early October.
- Also consider that US small cap Financials have not gone along for this drop. They remain comfortably above their late-October lows and are only down 3.5% on the year. Both US and European large cap Financials are making new lows on a daily basis just now.
So when will US large cap Financials finally bottom? Two thoughts:
#1. Valuation isn’t the answer; even bears will agree the group is cheap.FactSet currently shows S&P Financials trading for 11.1x forward earnings, the lowest sector valuation in the entire S&P 500. Even if you assume estimates are 20% too high, that still yields a 13x multiple in a market trading for 15.4x.
#2. The history of the sector weighting for Financials in the S&P 500 provides a more useful signal that also captures the capital markets cycle quite neatly. Here is how this works:
- At their current weighting of 13.1%, Financials are at their lowest percentage of the S&P 500 since May 2009, barring a one-month downdraft in September 2016. (We use month end data here).
- The average Financials weighting in the index since 2000 is 15.4%. When we showed a long time Financials analyst this dataset, he reminded us that going back any further ignores industry consolidation, IPOs and the growth of publicly held asset managers.
- The average weight of Financials since 2010 is a similar 15.5%. That this foots with the 2000-present experience gives us some confidence that this is a “normal” allocation to Financials across a cycle.
- The post 2000 troughs are June 2000 (12.7%) and February 2009 (9.7%).
The bottom line here: either US large cap Financials are near a bottom relative to the S&P 500 (like June 2000) or markets are still in the midst of discounting something much worse (like 2009). By any objective measure, it should be the former (a relative bottom). The US financial system is robust enough to withstand a “normal” recession, or the Fed’s annual stress tests are basically worthless. The group may not V-bottom, but it should be safe to even weight or perhaps even modestly overweight right here.
Our advice: a more positive view on this sector can wait a few weeks. We are big believers in “price leads fundamentals”. The recent coupling of US to European Financials is troubling, because the American financial system is nominally better capitalized than the Eurozone’s. Markets don’t seem to care…
And a final thought: we will be closely watching how US large cap Financials trade into year-end. They should stabilize soon, indicating a cyclical low in market sentiment. The group may not outperform, but it should match the S&P’s performance. If Financials continue to break down, that is very bad news indeed.
And judging by the slew of analyst downgrades, the suffering is far from over. As Bloomberg reports, this year’s 16 percent slide by major U.S. banks apparently isn’t enough for analysts, who are subjecting the sector to a fresh pummeling.
Keefe Bruyette & Woods Inc.’s Brian Kleinhanzl shifted his sector recommendation on the biggest banks to market weight from overweight, and turned cautious on the coming year. There aren’t enough “positive catalysts” ahead, other than "simply having a discounted valuation," to lift the group after underperformance driven by disappointing loan growth and macroeconomic risks, Kleinhanzl wrote in a note. Shares may keep dropping, with cuts to consensus estimates and credit worries unlikely to abate.
Flagging dimmer expectations for global and U.S. economic performance, KBW downgraded Bank of America Corp. and Morgan Stanley to market perform. “Low loan growth and rising deposit betas mean that net interest margin expansion will be limited broadly,” Kleinhanzl said.
Separately, KBW analyst Brian Klock wrote that the 2019 narrative may turn toward “defensive banks that can grow earnings using other levers rather than depending on rates.” Klock cut his recommendation on Comerica Inc. and KeyCorp to market perform, but recommends investors own Citizens Financial Group Inc., M&T Bank Corp., SunTrust Banks Inc. and Zions Bancorp.
Atlantic Equities’s John Heagerty downgraded Goldman Sachs Group Inc. to neutral and slashed his price target to $210 (near the Street low of $205) from $295 on fears about new CEO David Solomon’s strategy and Malaysia’s 1MDB corruption scandal. Heagerty also lowered his per-share profit forecasts due to “a more subdued environment for investment banking.” In particular, fixed income, currency and commodities revenues “are clearly coming under pressure as macroeconomic uncertainty increases,” while debt issuance is hurting as rates have risen and equity-capital-markets income may be damped amid greater market volatility.
And finally, on Tuesday, Morgan Stanley analyst Ken Zerbe wrote that the sector is prone to further weakness if economic fundamentals don’t improve. “The carefree days of rising rates and pristine credit quality could be coming to an end,” Zerbe said. “We cannot ignore the growing risk of a bear credit market next year preceding a recession as well as the negative impact of weaker economic growth.”
All in all, one has to wonder what is going on when the world's most systemically important banks' share prices have collapsed almost 40% from their highs (and erased all post-Trump gains)...
Is this all Deutsche fears, or something even bigger?