Cam Hui, CFA | cam@pennockideahub.com Page 1

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Quantitative & Strategy

CAN A BULL MARKET BEGIN WITHOUT THE BANKS?

July 20, 2020

EXECUTIVE SUMMARY

Earnings season has kicked off with reports from the major banks. The market reaction has

been mixed so far. From a big-picture perspective, history shows that whenever the relative

performance of banking stocks have breached a major support level, such events have

signaled periods of financial stress and bear markets.

This time, the COVID Crash saw the market fall and recover in the space of a few short

months. This begs two important questions for investors.

First, the financial sector is the third-largest weight in the index, behind technology and

healthcare. Can a bull market begin without the participation of a major sector like this?

Brian Gilmartin at Trinity Asset Management pointed out that the sector represents about

10% of index weight but 17% earnings weight, indicating that financial stocks are value

stocks. What does the lagging performance of these stocks mean for the growth/value

dynamic?

We believe investors should expect more pain ahead for the banking sector. The credit

cycle is not yet complete for the latest expansion cycle, and banks are bracing for a wave of

bankruptcies. The Fed is about to engage in financial repression that will depress banking

profitability. From a technical perspective, the relative performance of the NASDAQ 100

to the Bank Index isn’t washed out yet, indicating that growth is likely to dominate value

for the time being.

The banks will have their day, but not yet. By implication, there is one more leg down for

this bear market, and one more leg up for the growth/value trade before it’s all over.

Cam Hui, CFA cam@pennockideahub.com

Table of Contents

Do Banks Matter? .................................... 2

How Cheap Are Banks? ........................... 3

Waiting for the Next Shoe to Drop ............ 5

Financial Repression Ahead .................. 10

Brace for More Pain ............................... 12

Cam Hui, CFA | cam@pennockideahub.com Page 2

July 20, 2020

Quantitative & Strategy

Do Banks Matter?

Earnings season has kicked off with reports from the major banks. The market reaction has

been mixed so far. From a big-picture perspective, history shows that whenever the relative

performance of banking stocks have breached a major support level, such events have usually

signaled periods of financial stress and bear markets.

Exhibit 1: Trouble Ahead?

Source: StockCharts

This time, the COVID Crash saw the market fall and recover in the space of a few short

months. This begs two important questions for investors.

First, the financial sector is the third-largest weight in the index, behind technology and

healthcare. Can a bull market begin without the participation of a major sector like this?

Brian Gilmartin at Trinity Asset Management pointed out that the sector represents about 10%

of index weight but 17% earnings weight, indicating that financial stocks are value stocks. What

does the lagging performance of these stocks mean for the growth/value dynamic?

Cam Hui, CFA | cam@pennockideahub.com Page 3

July 20, 2020

Quantitative & Strategy

How Cheap Are Banks?

Financial stocks have lagged the market, not just in the U.S. but globally. The relative

performance of this sector has been synchronized globally in the last two years. Even in China,

banking stocks staged a relative rally when the Chinese market surged, but their relative returns

have retreated as the market cooled off.

Exhibit 2: Financial Stocks Have Lagged Globally

Source: StockCharts

How cheap are they? Callum Thomas at Topdown Charts found that global banks are indeed

very cheap by historical standards, whether measured by a relative PB ratio or relative PE10

ratio. He observed that global banks have never been cheaper based on both absolute and

relative valuation, and they trade at a “massive 60% discount to the rest of the market on a

PE10 basis”.

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July 20, 2020

Quantitative & Strategy

Exhibit 3: Banks Are Cheap on PE10 and PB

Source: Topdown Charts

That may not be enough from a sentiment perspective. The BoA Global Fund Manager Survey

reported that managers are underweight banks, but sentiment does not appear to be panicked

in the manner of the Great Financial Crisis of 2007–2009.

Exhibit 4: Global Managers Are Underweight Banks, But Sentiment Not Washed Out

Source: BoA Global Fund Manager Survey

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July 20, 2020

Quantitative & Strategy

Waiting for the Next Shoe to Drop

We would argue that this sector has not seen the capitulation event needed for a turnaround.

In the past, periods of financial stress has been associated with banking crises. We have not had

the credit event that sparks a banking crisis just yet. The latest BoA Global Fund Manager

Survey shows that investors are overly focused on the COVID-19 Crisis, and the risk of a credit

event is barely in the spotlight.

Exhibit 5: A Credit Event Barely Registers as a “Tail Risk”

Source: BoA Global Fund Manager Survey

That may be about to change. Just when you thought the banks had “kitchen sinked” by writing off all of the bad loans in Q1, Bloomberg reported that JP Morgan, Citigroup and Wells Fargo had set aside about $28 billion in loan loss provisions in Q2.

Exhibit 6: Bad Debt Provisions Are Rising

Source: Bloomberg

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Quantitative & Strategy

Is this as bad as it gets? We are not sure. Just consider some of these comments from banking

CEOs during the earnings calls.

“This is not a normal recession. The recessionary part of this you’re going to see down the road,”

JPMorgan Chief Executive Officer Jamie Dimon said Tuesday. “You will see the effect of this

recession. You’re just not going to see it right away because of all the stimulus.”

“I don’t think anybody should leave any bank earnings call this quarter simply feeling like the worst

is absolutely behind us and it’s a rosy path ahead,” Citigroup CEO Michael Corbat told analysts.

“We don’t want people leaving the call simply thinking the world is a great place and it’s a V-shaped

recovery.”

Banking executives are echoing the message of the Fed. The path of the recovery depends on

progress against the pandemic. This is not your father’s recession.

The number of corporate bankruptcies has spiked to levels last seen during the last crisis,

though the value of liabilities in bankruptcy is still relatively tame.

Exhibit 7: Corporate Bankruptcies Are Surging

Source: Sober Look, Wall Street Journal

The slowdown is also starting to bite into the household sector. A study by the nonpartisan

consumer advocacy group Families USA found that a record 5.4-million Americans had lost

their health insurance between February and May. In addition, high-frequency economic data

shows that consumer spending began to roll over in mid-June. What’s more even worrisome is

the high-income households, who have the greater propensity to spend, that are leading the

decline.

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Quantitative & Strategy

Exhibit 8: Consumer Confidence Rolls Over

Source: Morning Consult

Mortgage delinquencies, which were the first signs of the last housing crisis, have surged.

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Quantitative & Strategy

Exhibit 9: Mortgage Delinquencies Are Surging

Source: CoreLogic

The CEO of Apartment List gave further details on housing market stress in the latest earnings

call:

During the first week of this month, 19 percent of Americans had made no housing payment, while

an additional 13 percent paid only a portion of their monthly bill... From June to July, the share of

renters who are either “very” or “extremely” concerned about being evicted rose from 18 percent to over

21. Similarly, the share of homeowners concerned about foreclosure ticked up from 14 percent to 17

percent.

So far, the fiscal support provided by the CARES Act is creating a limited safety net for

consumer spending. Joe Wiesenthal at Bloomberg observed that despite record job losses, total

compensation for unemployed workers actually rose because of the CARES Act, whose

provisions are set to expire at the end of July. For some perspective on the scale of fiscal

support, George Pearkes at Bespoke estimated that a full expiry of the $600 per week

unemployment insurance payment would cost the household sector 4.8% of Q1 nominal GDP

at an annualized rate.

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July 20, 2020

Quantitative & Strategy

Exhibit 10: CARES Act Payments Have Provided a Big Safety Net

Source: Bloomberg

Whether any fiscal support is forthcoming is an open question. The latest tentative proposal

from the administration calls for a reduced level of support that is capped at $1 trillion, plus a

payroll tax cut. The House Democrats passed a $3 trillion relief bill with very different spending

priorities. It is unclear whether both sides of the aisle can come to an agreement before the

Congress recess in August.

Cam Hui, CFA | cam@pennockideahub.com Page 10

July 20, 2020

Quantitative & Strategy

Financial Repression Ahead

How is the Fed likely to react? Fed watcher Tim Duy analyzed a recent speech by Fed governor

Lael Brainard and concluded that the Fed is likely to engage in yield curve control. Brainard

began with an assessment of the path of recovery, and provided a Fed policy roadmap.

Looking ahead, it will be important for monetary policy to pivot from stabilization to accommodation

by supporting a full recovery in employment and returning inflation to its 2 percent objective on a

sustained basis. As we move to the next phase of monetary policy, we will be guided not only by the

exigencies of the COVID crisis, but also by our evolving understanding of the key longer-run features

of the economy, so as to avoid the premature withdrawal of necessary support.

She went on to open the door to yield curve control (YCC) as an additional policy tool.

Forward guidance and asset purchases were road-tested in the previous crisis, so there is a high degree

of familiarity with their use. Given the downside risks to the outlook, there may come a time when it

is helpful to reinforce the credibility of forward guidance and lessen the burden on the balance sheet with

the addition of targets on the short-to-medium end of the yield curve.

Duy concluded:

The Fed will feel pressure to do more without expanding the balance sheet further. That leaves yield

curve control as the next likely path forward. [Though] they have to talk it out first.

The Fed last engaged in YCC during World War II, which forced savers to subsidize the

government's finances. Let’s call it what it really is, financial repression. We have seen what

different forms of financial repression does to the banking system. In the eurozone, the ECB

pushed rates deeply negative, and it cratered bank profitability. The difference becomes obvious

when we compare the performance of U.S. and European banking stocks in the last decade (all

figures in USD).

Exhibit 11: European Financial Stocks Have Been Flat in the Last Decade

Source: StockCharts

Cam Hui, CFA | cam@pennockideahub.com Page 11

July 20, 2020

Quantitative & Strategy

We also have a real-time price signal for the degree of financial repression. The price of gold

responds to real interest rates. If the Fed were to artificially push down real rates, it puts upward

pressure on gold. As the following chart shows, the relative performance of bank stocks are

inversely correlated to gold.

Exhibit 12: Bank Relative Performance Inversely Correlated to Gold

Source: StockCharts

Cam Hui, CFA | cam@pennockideahub.com Page 12

July 20, 2020

Quantitative & Strategy

Brace for More Pain

In conclusion, investors should expect more pain ahead for the banking sector. The credit cycle

is not yet complete for the latest expansion cycle, and banks are bracing for a wave of

bankruptcies. The Fed is about to engage in financial repression that will depress banking

profitability. From a technical perspective, the relative performance of the NASDAQ 100 to

the Bank Index isn’t washed out yet, indicating that growth is likely to dominate value for the

time being. Historically, the relative performance of this ratio has not bottomed out until the

52-week rate of change reaches -70%. That said, the 14-week RSI is exhibiting a positive

divergence, which is a signal that the final capitulation is near.

Exhibit 13: Banks vs. NASDAQ 100

Source: StockCharts

The banks will have their day, but not yet. By implication, there is one more leg down for this

bear market, and one more leg up for the growth/value trade before it’s all over.

Cam Hui, CFA | cam@pennockideahub.com Page 13

July 20, 2020

Quantitative & Strategy

Disclaimer

I, Cam Hui, certify that the views expressed in this commentary accurately reflect my personal views about the subject company (ies). I am

confident in my investment analysis skills, and I may buy or already own shares in those companies under discussion. I prepare and edit

every report published under my name. I depend on my colleagues for constructive criticism on my research methods and conclusions but

final responsibility is my own.

I also certify that I have not and will not be receiving direct or indirect compensation from the subject company(ies) in exchange for publishing

this commentary.

This investment analysis excludes any target price, and is not a recommendation to buy or sell a stock. It is intended to provide a means for

the author to share his experience and perspective exclusively for the benefit of the clients of Pennock Idea Hub (PIH). My articles may

contain statements and projections that are forward-looking in nature, and therefore subject to numerous risks, uncertainties, and

assumptions. The author does not assume any liability whatsoever for any direct or consequential loss arising from or relating to any use of

the information contained in this note.

This information contained in this commentary has been compiled from sources believed to be reliable but no representation or warranty,

express or implied, is made by the author or any other person as to its fairness, accuracy, completeness or correctness.

This article does not constitute an offer or solicitation in any jurisdiction.

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