There has been a significant divergence between the performance of stocks and bonds so far in October, and we think that gap in performance is creating a potential opportunity in one sector of the stock market that can help clients outperform into year end.
Specifically, the S&P 500 is up 9% in less than a month, while bond yields virtually unchanged over the same period.
Does that strike anyone else as odd?
It should, because when stocks rally that much it’s usually accompanied by a similar rise in bond yields, but that’s not happening.
Here’s why (and what it means):
First, Chinese growth concerns and emerging market turmoil was the reason stocks collapsed in August/ September.
Second, the stock market correction caused the Fed not to hike rates in September, which made bond yields fall.
Now, Chinese data has gotten better and the stock market is up, which means the Fed should be on course to raise rates. That should send bond yields higher.
But it hasn’t.
And, that’s because bond yields are now reflecting the potential for a slowdown in the US economy – and the fact that bond yields remain so low is a big non-confirmation signal on this recent stock market rally.
So, one of two things is going to happen:
Economic data in the US will stabilize, stocks will keep going up and interest rates will rise as the Fed gets closer to hiking rates, or
Economic data in the US will get worse, the chances of a recession will increase, stocks will drop and interest rates will remain low.
It’s going to be one or the other, and that’s why we are so focused on the economic data for our paid subscribers – because we want them to know right away which it’s going to be.
But, in the meantime, we believe we’ve identified a sector of the market that has recently underperformed but that has the potential to significantly outperform the S&P 500 into year end, and given this current market set up, offers a compelling risk/reward profile for tactical investors.
Why Bank Stocks Can Outperform (Sevens Report Excerpt)
We think this macro environment creates an attractive risk/reward set up for banking stocks, because they:
- Just reported earnings that confirm positive macro fundamentals,
- Have underperformed based on a peripheral headwind that’s already priced in and
- Offer the potential to outperform into yearend if stocks keep rallying, but also will trade in-line with the broad market should stocks roll over from here, offering greater reward but no additional risk.
Bullish Reason #1: Strong Fundamentals: The Q3 reporting season for bank stocks is almost over, and it’s fair to say that overall the results “aren’t as bad as feared.” Specifically, there were two areas of concern that were almost universally refuted by both multi-national and regional bank earnings:
- First, consumer loan growth remains strong, with many banks reporting 6% – 7% q/q consumer loan growth. That’s important because it shows the US consumer remains strong, and that from a macro standpoint, loan growth remains a tailwind on the banks revenues.
- Second, credit quality remains near the best levels in years. The concern going into earnings was that oil and energy related companies would start to default on loans, following the collapse of oil prices and that hasn’t happened.
Positively, bank management commentary surrounding credit quality (specifically in the energy patch) was “fine” and as a broad statement, credit quality for consumer and corporations remains as healthy as it’s been in years.
So, Positive Loan Growth + Strong Credit Quality = A Good Macro Environment for Banks.
Bullish Reason #2: Recent Underperformance Creates Opportunity.
Despite this improvement in the fundamentals, bank stocks have recently underperformed the market.
Since the lows on September 29th, our favorite bank ETF is up just 3.71% vs. 7.98% for the S&P 500.
The reason? Interest rates.
Bank stocks, fairly or not, are now being traded as a proxy for the outlook for interest rates, because interest rates effect a banks “Net Interest Margin,” which is a general proxy for a bank’s profitability.
So as the Fed has gotten more “dovish”, interest rates have declined and the bank stocks have been dragged down with them.
But, as we said earlier, the spread between rates and the stock market has to be resolved, and unless you think we are heading into a recession or the Fed will never raise rates, then banks are attractive here because they have strong macro fundamentals and an interest rate “worst case” scenario already priced in.
If rates start to rise, though, then banks should significantly outperform the S&P 500 into year end, offering the potential for your clients to outperform.
Bullish Reason #3: Potential Higher Reward but no Significant Additional Risk.
If the worst case occurs and US economic data continues to lag, then banks stocks likely aren’t going to get hit harder than anything else. The beta of our preferred bank ETF (which is not XLF) has a beta very close to 1.00 and from the 2015 highs to the closing low (so early July to late August) this ETF declined basically the same as the S&P 500.
Point being, if rates rise, you’re giving your clients the potential to significantly outperform, and if the market rolls over, you’re not taking on significant risk beyond what you can expect from the broad market.
Finally, selection matters.
- Trading Revenues in Q3 were very disappointing, so based on that you want to stay away from banks with large trading departments.
- Housing remains strong (arguably the strongest sector of our economy) so you want exposure to banks that are focused on mortgage loans and housing related loans.
- Consumer sentiment/spending also remains high, so you want banks with exposure to consumer lending and credit demand.
Those factors mean that we have to be more specific than buying just XLF because we believe conventional banks specifically can outperform investment banks and insurance companies (which make up a large portion of XLF).
Bottom line, we do view all this recent market turmoil as a longer term opportunity to get clients with the appropriate time horizon into quality sectors that can outperform over the coming quarters and years. We think banks (that make up our preferred ETF) are one of those sectors.
Our goal at The Sevens Report is to provide daily macro analysis as well as actionable, tactical investment strategies that can help your clients outperform.
Every day in the Report, we provide our “7 Best Ideas,” which contains tactical strategies and specific ETFs that we think can outperform the markets.
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