This note was originally published
at 8am on July 03, 2012.
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“The fellow that can only see a week ahead is always the popular fellow, for he is looking with the crowd. But the one that can see years ahead, he has a telescope but he can't make anybody believe that he has it.”
To Will Rogers’ point, telescopes are in short supply these days. Ask an investor what they would have predicted for the XLF three years ago, and chances are their reply wouldn’t have looked much like the chart at the end of this note. The reality is that it’s a natural investor tendency to extrapolate the recent past as the most likely path for the next twelve months of trading. Obviously, the problem with this approach is that it misses big turning points.
Looking at the last three years there have been at least six big turning points in the Financials space. We’re not talking about small rallies or corrections. Being on the right or wrong side of these big moves has made or broken investors’ years.
What’s so interesting to us is that in hindsight they seem to follow a very recurring and seemingly predictable pattern. The XLF peak in 2010, 2011 and 2012 occurred on April 14, February 21 and March 26, respectively. The XLF low for those same years occurred on August 30, 2010, October 3, 2011 and as-yet-to-be-determined, 2012, though no earlier than June 4.
We’ve come up with a framework for thinking about why the pattern seems to rhyme so consistently over the last three years. The foundation of the framework is the distortion of government economic data, which was introduced by faulty seasonal adjustment factors arising from Lehman Brothers’ bankruptcy. The recurring annual effect makes many of the government’s data series appear stronger than they really are from September through February and weaker from March through August. We’ve quantified this effect in the initial jobless claims series, and it is strong enough to create the illusion of both robust recovery in Q4 and Q1 of each year and an economy teetering on the brink of recession in Q2 and Q3. Given that we just entered Q3 on Monday, we think the effect still has a few months to go before predictably beginning to reverse.
The second thing to understand is that central banks play a predictable role in exacerbating this trend. As the data appears to weaken steadily over the course of the March through August period, the calls for QE grow louder. In 2010 this culminated at Jackson Hole with the unveiling of QE2. In 2011 QE-Light (aka Operation Twist) was unveiled in September while the ECB’s large-scale LTRO program came out that December. The takeaway here is that the announcement or start of these massive intervention programs coincides with the turning point in the cycle when the economic data is already beginning to roll from bad to good.
This phenomenon is likely to be with us for the next two years. Government seasonality models work on a five year look back, this being the third year following the incorporation of the original data distortion. As such, we’d expect to see this effect present itself again in 2013 and again in 2014. That said, the effect should become progressively smaller, as the government models weight older years less heavily than more recent years.
There are other factors at play. For instance, May 2010 saw Dodd-Frank roll out – a major Financials sector overhang. 2011 saw the debt ceiling debate culminate in the S&P downgrade of the United States. Additionally in 2011, the large cap banks were plagued by mortgage putbacks and Basel III SIFI concerns; none more so than Bank of America. And, of course, Europe has played a central and recurring role in the last three years. This year it’s a combination of Europe (again) and angst over how punitive the Volcker Rule will be for the large banks.
Looking ahead, the most likely candidate on the radar for the next large-cap bank boogeyman is the rapidly emerging LIBOR scandal. So far it has claimed only Barclays as a victim, as that bank agreed to pay three regulators a total of $451 million in penalties in addition to actually admitting wrongdoing – when was the last time you heard a bank admit that? Specifically, the bank has acknowledged that it deliberately reported artificial borrowing rates from 2005 through 2009. The company’s Chairman resigned over the weekend and CEO Diamond bowed to the pressure to resign this morning. Barclays got a slap on the wrist in exchange for enormous cooperation in helping regulators understand the extent of the wrongdoing. Remember that price fixing is a criminal violation under the Sherman Act, so Barclays was treated with kid gloves. The fear that the large US banks will be treated less favorably is appropriate.
There are approximately $10 trillion in loans tied to Libor and another $350 trillion in notional value derivative contracts linked to the rate. Just one basis point of that notional total, for reference, equates to $36 billion. Early indications suggest that Libor may have been manipulated by as much as 30-40 bps, though this has yet to be confirmed. Any way you slice it, the math is big. Back in the Fall of 2010 we estimated that the mortgage putback fiasco would cost the big banks $49 billion in total, with Bank of America shouldering almost half that amount. Putbacks were the principal concern driving BAC shares down to $4.99 (38% of tangible book value). Given the magnitude of the affected securities in this scandal, it doesn’t seem hard to imagine a class action process that reaches into the tens of billions of dollars, with fears and chatter about “hundreds of billions”. We expect this issue to heat up over the coming 12 months as there are active investigations by the Dept. of Justice into all the large banks involved in setting LIBOR. Domestically, JPMorgan, Citigroup and Bank of America appear at risk.
Perhaps the most important thing to understand is that the big banks have, in the last few years, been overshadowed by one cloud of uncertainty after another: mortgage putbacks, AG settlements, Durbin, Reg-E, Volcker, etc. Until it’s crystal clear to the market how much an issue is going to cost and/or how detrimental it will be to the business going forward, the market shoots first and asks questions later. This Libor scandal fits that mold perfectly: it’s big, it’s as yet unquantifiable and the media is in the bottom of the first inning getting its arms around what’s happened. The numbers that will start to get thrown around will be staggering: “trillions”. Very few investors, as well as the banks themselves for that matter, will have any real handle on what the loss profile may look like. As such, the prospects for the large banks finally achieving escape velocity out of their March 2009 to February 2011 price/tangible book value ranges is unlikely over the next year.
As a final point, it’s worth pointing out where we are in this current cycle. It certainly looks as though 6/4/12 was a possible major turning point. From our vantage point the most glaring difference between this year and the last two years is the level of recorded fear. In both 2010 and 2011 the VIX exceeded 45 briefly and traded for some time above 30. So far in 2012 the VIX has only exceeded 25 on a few days and hasn’t exceeded 30 at all. Considering this emerging LIBOR scandal and that the problems in Europe seem larger today than what we faced in 2011 or 2010, it strikes us as counterintuitive that the market would be less afraid today.
Our immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar, EUR/USD, Germany’s DAX, and the SP500 are now $1593-1615, $92.99-98.53, $81.41-82.31, $1.23-1.27, 6284-6581, and 1337-1373, respectively.
Josh Steiner, CFA