Bank stocks will continue to underperform. It’s the business cycle (KBWB)

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My January 2021 article (here) concluded:

…rising yields at the start of an economic cycle are good news for bank stocks. Rising yields to levels damaging the economy and driving down the business cycle is bad news for the banking sector.

To understand what is happening now, it is useful to look at how the banking sector reacts to changes in the business cycle.

business cycle

Profiting from Bull or Bear Markets – How Business Cycles Affect Financial Markets

The business cycle goes through four distinct phases. The trends pointing towards the end of phase 4 are:

  • Commodities and inflation are down.
  • Sales growth is less than the rate of inventory accumulation.
  • Income after inflation begins to rise.
  • Consumer confidence rebounds as consumers react favorably to lower inflation, interest rates and rising real income.

These favorable developments create the conditions for the economic cycle to enter phase 1. Increase in sales thanks to consumers‘ improved financial conditions. Businesses are forced to increase production to build up inventory to meet growing demand. Businesses will need to hire new people, buy raw materials, and increase borrowing to improve and eventually expand capacity.

These activities place a floor on commodities and interest rates. As the positive feedback continues, improving sales are translating into increased inventory, increased employment and increased borrowing.

This expansion benefits the banking sector, of course, as it provides the necessary liquidity to fuel the positive loop, thereby creating even more growth. This is when bank stocks outperform the market.

However, there comes a time when the high level of production puts upward pressure on commodities, interest rates and inflation. The economic cycle enters phase 2, reflecting an even stronger economy.

But rising commodities, interest rates, and inflation eventually have a negative impact on consumer finances, as they are now. Consumer confidence peaks and then declines. Demand for goods is slowing.

Companies recognize that inventories are now rising too quickly due to slowing demand and are negatively impacting profits. Production is reduced. Purchases of raw materials are reduced. Hiring is cut. Upgrades and capacity expansions are delayed, resulting in lower borrowing, an unwelcome development for banks.

Where are we now?

business cycle

StockCharts.com, Strategy and Portfolio Management Peter Dag

The graph above shows the economic indicator updated in real time from market data and revised in each issue of Strategy and portfolio management Peter Dag. It shows the two previous cycles (2011-2014 and 2014-2020) and the current one started in 2020.

This indicator and data on the growth of truck sales, post-inflation revenue, post-inflation retail sales and the action of the defensive sectors of the market (see below) confirm that the business cycle is now down, reflecting slower economic growth. The economic cycle is now in phase 3.

The downturn process will continue until the causes that produced it are brought under control and consumers recognize that their finances are improving. This new environment will be characterized by falling inflation and interest rates. This process will take place in phase 4, the most painful phase for consumers and financial markets.

During Phases 3 and 4, the sectors that outperformed the markets were Utilities (XLU), Healthcare (XLV), Commodities (XLP), REITs and long-duration Treasuries. This relationship has been discussed in detail in my article here.

The performance of different sectors repeats itself as the economic cycle oscillates between periods of stronger and weaker growth.

stock sectors

StockCharts.com, Strategy and Portfolio Management Peter Dag

The sectors that outperformed the market over the last two hundred days (excluding energy) were the four sectors mentioned above. Their performance confirms that the economic cycle is in decline, reflecting a declining economy.

The financial sector, and banks in particular, is a cyclical sector that outperforms the market during periods of economic cycle strengthening.

chart

StockCharts.com, Strategy and Portfolio Management Peter Dag

The chart above shows the ratio of the Invesco KBWB banking ETF and the S&P 500 ETF (KBWB/SPY ratio). The ratio increases when bank stocks outperform the market. The ratio declines when bank stocks underperform the market.

The bottom panel of the chart above shows the calculated real-time business cycle indicator as reviewed in each issue of Strategy and portfolio management Peter Dag.

The chart shows that bank stocks outperform the market (ratio increases) when the business cycle increases, reflecting a strengthening economy. The ratio declines, reflecting the underperformance of bank stocks, when the business cycle indicator declines in response to a weakening economy.

chart

StockCharts.com, Strategy and Portfolio Management Peter Dag

The chart above shows regional bank stocks (ETF: KRE) react like the actions of the major central banks to changes in the economic cycle. They outperform the market when the business cycle indicator rises and underperform the market when the business cycle indicator falls.

chart

StockCharts.com, Strategy and Portfolio Management Peter Dag

Even large, well-managed banks like JPMorgan (JPM) are not immune to changes in the economic cycle, as the chart above shows. JPMorgan’s stock outperforms the market when the business cycle is up and underperforms the market when the business cycle is down.

Key points to remember

  1. Bank stocks react to changes in the business cycle, not interest rates.
  2. Bank stocks outperform the market when the business cycle increases, reflecting a strengthening economy (Phase 1 and Phase 2 of the business cycle).
  3. There comes a time when rising interest rates and inflation lead to a downturn in the business cycle. This is when bank stocks start to underperform (Phase 3 and Phase 4 of the economic cycle).
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