May 31, 2016

Current Banking sector rally may not have the legs to continue

The iShares 20+ Year Treasury Bond ETF was +$0.80 at last check as bond prices rise and yields fall. The 10 and 30 year Treasury yields are both lower, the yield curve is flat and the two-year/10-year Treasury spread is basically at a multi-year low.

There's no sign whatsoever of the yield curve steepening, even though that's what the bank sector's bulls have cited to justify the recent rally in financials.

In other words, waiting for the yield curve to normalize might be like waiting for Godot! While I continue to believe that banks offer outstanding value on a multi-year basis, I'd recommend traders and investors who have six-month time horizons or less consider selling off a portion of their bank holdings.

As you probably recall, I took all nine banks on my "Best Long Ideas" list off of the rundown back in mid-March.

It turns out that I was early in selling off the stocks three months ago. But while I continue to believe that banks offer great multi-year value, I see a number of threats for the sector over 2016's balance. These include:

Overly Optimistic Earnings Estimates
I still believe that analysts' 2016-17 earnings forecasts for banks are too high (although only modestly so).

I note that the two-year/10-year U.S. Treasury spread recently went below 100 basis points, or more than 150 basis points under what we saw a few years ago. That's bad news for banks, which rely on credit spreads to make money.

Unfortunately, my baseline expectation for the next few quarters is that we'll see the yield curve continue to flatten. After all, the Purchasing Managers Index and other recent indicators point to U.S. growth that's disappointing relative to expectations.

A Rally That's Already Happened

Banks have enjoyed a spirited rally recently. But to me, the time to buy banks stocks was months ago, when share prices languished out of disinterest.

A Tame Fed

I still expect that we won't have any Federal Reserve rate hikes this year. That's a non-consensus view, but if I'm right, continued low rates should be bad for banks.

Fair Valuations

Bank-stock valuations are reasonable right now, but they're no longer cheap.

And given the fundamental headwinds that I see for the sector, it's hard to envision banks enjoying much expansion to their multiples from here.

Political Problems
I expect financial firms to face renewed political threats from both Democratic presidential candidate Hillary Clinton and her Republican rival Donald Trump.

The Bottom Line

Add it all up and I see few catalysts for bank stocks away from a rotation into the space. Frankly, I don't see much rationale for this strength to continue."

Position: Short XLF