Pictures du Jour: Banks to indicate direction for stock market

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Global stock markets topped out on the back of the sub-prime/credit debacle in October 2007. Prices subsequently moved lower until reaching climatic bottoms in January/March this year, triggering rallies throughout the world until a few days ago. The big question investors are grappling with at this stage is whether the rise in prices has simply been a bear market rally, or whether we are back in a primary bull market.

I have previously said: “Whereas I am doubtful about the longevity of the rally, I am also not in the Armageddon school. Is the answer perhaps a ‘muddle-through’ market, characterized by below-average returns? That is my hunch, for what it’s worth.” (See post entitled “Poll of the Week: Stock Markets – Which Way Jose?” of 25 April 2008.)

In searching for answers, it is appropriate trying to get a grip on the direction of banking stocks as these are usually a good indicator of the market as a whole, especially given the large proportion of financial services of many major stock markets.

The following is a long-term chart of the S&P Banking Index relative to the S&P 500 Index, showing clearly the massive underperformance of banking stocks since the middle of 2002:

banks-1.jpg

Sources: Bloomberg; I-Net; Plexus Asset Management.

I have pulled out a few fundamental graphs pertaining to the US situation in order to assist in gauging the lie of the land.

Firstly, as far as lending standards are concerned, US banks are still in tightening mode.

banks-2.jpg

Sources: Federal Reserve Board; I-Net; Plexus Asset Management.

But it would appear that the lending standards could start easing during the current or next quarter, at least when considering the historical relationship with the Fed funds rate.

banks-3.jpg

Sources: Federal Reserve Board; I-Net; Plexus Asset Management.

Interestingly, banking stocks have historically started outperforming the S&P 500 Index around two to three quarters before lending standards ease.

banks-4.jpg

Sources: Federal Reserve Board; Bloomberg; I-Net; Plexus Asset Management.

The relative performance of banking stocks is largely driven by the “mortgage margin”. The latter has been defined for this purpose as the difference between the 30-year mortgage yield and the 30-year government bond yield, serving as a measure of risk in the housing market.

banks-5f.jpg

Sources: Federal Reserve Board; Bloomberg; I-Net; Plexus Asset Management.

Taking the analysis one step further, the mortgage margin in turn leads the lending standards by about two quarters.

banks-6.jpg

Sources: Federal Reserve Board; I-Net; Plexus Asset Management.

The next graph shows the relationship between the mortgage margin and the Fed funds rate.

banks-7.jpg

Sources: Federal Reserve Board; I-Net; Plexus Asset Management.

Putting all this together, it would appear that the underperformance of US banking stocks relative to the S&P 500 Index could be on its last legs. This conclusion is based on the mortgage margin appearing to be peaking, the Fed funds rate leading the lending standards by approximately three quarters, as well as the relationship between the mortgage margin and the Fed funds rate.

Caveat emptor: This is a relative analysis and does not provide a tool for short-term timing decisions. It does, however, alert one to the factors at play regarding the performance of banking stocks – factors beginning to point to the possible initial stages of the long-term bottoming out in the relative performance of banking stocks and, ultimately, to better prospects for stock markets as a whole.

 

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5 comments to Pictures du Jour: Banks to indicate direction for stock market

  • Michael Mennell

    voodoo economics. House prices in USA as well as UK, Spain, Italy, France are falling strongly. From what i gather houses in parts of RSA doing the same. Hence, would you buy RSA banking stocks in current climate?
    The bottom of this fall is miles away. The graphs presented do not include a period when house prices have fallen strongly and are still falling.
    This is a bear market rally.

  • Dan Modricker

    I’ve been investing since 1963. Based on my perception, neither the U.S. economy nor the U.S. stock markets are going anywhere. Call it “muddle thru” if you like, but I refer to this type of period as “Stag-flation”; the toughest time to invest for even a long-term profit.

  • Don: Please see the following post, motivating why we may very well be dealing with sub-optimal returns for quite a number of years: http://www.investmentpostcards.com/2008/02/27/us-stock-market-returns-%e2%80%93-what-is-in-store/

  • From your charts, there could indeed be a recovery trend for the banks but any boom in the real economy is miles away.

    Nevertheless, it is a good reference for us to work out our own analysis of future market trend.

    As they say, luck favors the brave, enter the market when others are wary.

    Jeff
    http://jeflin.net

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