Bank Sector Watch
(June 1, 2004)
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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:
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
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.