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Bank Sector Watch

(June 1, 2004)

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Dear Readers:

The Bank Sector: Do I like the bank sector and the financial stocks?  Honestly, I don't.  I really don't.  Not only are valuations not attractive but I also believe that the yield curve is probably as steep as it is going to get.  The banks have been making a huge amount of money by borrowing short and lending long for the last 12 months, as exemplified by the following chart:

Philadelphia Bank Index

 

Please note that the Philadelphia Bank Index made an all-time high as recently as ten weeks ago - the key is when and how much the Federal Reserve will raise the fed funds rate over the next 12 months or so.  Please keep in mind that it is not a given that the Fed will raise rates over the next few months.  If either consumer confidence or job growth lags, then the Fed will have a legitimate reason to keep short-term interest rates as low as they are now, even as long-term rates continue to increase.  If that happens, then the yield curve will grow even steeper.  After all, this is an election year.

How about relative strength?  The following is a weekly chart of the Bank Index vs. the S&P 500.  This chart is at a multi-year high - again, suggesting that financial stocks are vastly overvalued here (given the fact that I also believe the S&P 500 is still in overvalued territory).  Technicals suggest that relative strength may have topped out:

 

Relative Strength (Weekly Chart) of the Bank Index vs. the S&P 500 (February 1993 to Present)

 

However, tops in the stock market, in major indices, and even in some individual stocks take a long time to form, so it is probably still too premature to call a top here.  In fact, if the relative strength of the Bank Index has not topped out yet, then one can make a case then we are oversold per the weekly chart.  Since the author believes that the S&P 500 will make a higher high (please see my regular commentary to see why) in the upcoming months, then it is probably too premature to be going short the financial sector.

In terms of sentiment, I also do not like the fact that everyone and their grandmas are calling for a top in financial stocks, mortgage stocks, and homebuilding stocks.  To them, it is obvious.  For example: http://www.businessweek.com/magazine/content/04_23/b3886127.htm.  The author of this Business Week article states that in most markets (I personally believe that this should extend to "all markets") the top is only clear in retrospect - except for banks and mortgage lenders in the latest boom.  Somehow, I just don't think it will be so easy.  Please keep in mind that higher interest rates do not necessarily mean a bust in the bank or the homebuilding industry.  As long as the average American keep on borrowing money, then the banks will continue to make their profits (whether they will keep it in the longer run is another story).  In fact, the banks will make even more money assuming that short-term rates remain as low as they are now.  This is a very feasible scenario, as both housing prices and home sales have historically had the highest positive correlation with people's income here in the U.S (and unemployment has consistently been decreasing).  In fact, interest rates do not have a significant historical correlation with either home prices or home sales, although it has appeared that way in the last few years.  The author's guess is that until the yield of the long bond rises over 6%, the banks and the mortgage lenders will continue to hold together.

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