Short the Financials

02/22/19 09:17AM EST

“Things can only go worse from here.”
-Jelena McWilliams 

That’s what the FDIC Chairwoman said after yesterday’s press release that US banks posted record annual profits of $236.7 billion in 2018, up +44% YoY. Impressively, net income would’ve hit a record high of $207.9 billion even without corporate tax reform, which was obviously an added bonus. Queue countervailing statements from The Bern, #AOC and Liz “Robin Hood” Warren. 

With respect to financial stability, no bank failed in 2018 – the first such year in which zero banks went into receivership since 2006. McWilliams was quick to eschew that figure: 

“It’s not lost on us that it’s been a while since we had the last bank failure. And while I would like to believe this is the new normal, it’s not.” 

Clearly McWilliams understands cycles. Rather than employ linear forecasting tools to extrapolate cycle-peak profitability well into the future, she understands the probability of mean reversion is highest usually right around when investor consensus believes it the least. McWilliams is the kind of cyclically oriented analyst who would do well on our data-driven independent research platform. 

Sidebar: It’s weird to have to write “data-driven” there, as that distinction should be implied for any purveyor of research services, but after ingesting some of the intellectually dishonest hogwash I’ve read over the past few weeks about why stocks are a buy from here, I’m inclined to double down on our distinction as one of the leading data analytics firms in finance.

Back to the Global Macro Grind… 

Short the Financials - z Financials cartoon May 2016

What a year 2018 was for US banks: 

  • Cycle-peak net interest income growth of +8.1% YoY in 4Q18;
  • Cycle-peak ROA of 1.35%, up from 0.97% in 2017; and
  • Cycle-peak conforming loans, with a 90-day delinquency rate dropping below 1%, the lowest proportion since 2007. 

Q: What do all these cycle-peaks have in common?
A: Cycle-peak rates of growth and inflation in 2018. 

Indeed, “record US bank profits” is the type of headline you should expect to see after a record nine-quarter run of accelerating YoY Real GDP growth that culminated with cycle-peak Nominal GDP growth of +5.5% YoY in 3Q18. 

It’s worth mentioning that a week from today it’ll be March of 2019. 

The reporting of the aforementioned cycle-peaks is probably why the Financials have rallied to one of the most obvious shortable lower-highs I’ve seen in my decade-long career on Wall Street. I usually don’t mention my PA in this forum because my trade lots are not very consequential after working at a startup for a meaningful proportion of the past 10yrs, but I cannot express to you how excited I am to load up on XLF puts on another up open on the heels of another Trump/Xi headline. 

Sunny D PA profits won’t be the talk of the town at some Fairfield County watering hole anytime soon, but as long as they help me finance excess rosé consumption out east this summer, I’m happy. Cycle-peak rosé pricing is another thing I’m looking to short, post Labor Day. 

So what’s my thesis on being short the Financials? That’s easy – the pivot to #Quad3, which is finally being confirmed the past week or so with WTI holding @Hedgeye TREND support of $55.33/barrel and with Oil Volatility (OVX) at the critical 30 level again. A breakdown through 30 on the OVX is the “all-clear” signal we believe investors should wait for before putting the #Quad3 portfolio on in size. CFTC net non-commercial futures and options positioning for crude oil have a 1yr Z-Score of -1.4x per the latest data (late-JAN, due to the gov’t shutdown), which implies a further short squeeze in price is more likely than not. 

Going back to the Financials, #Quad3 is where this sector has struggled the most in both absolute and relative terms.

Specifically, the S&P 500 GICS Level 1 Financials Index has the lowest expected value of any of the 11 S&P 500 sectors in #Quad3, and 15 of the 19 subsector and industry indices we track within Financials that have historical observations in #Quad3 have negative expected values, with Thrifts & Mortgage Finance, Capital Markets, and Investment Banking & Brokerage leading the way to the downside. Indeed, these industries have three of the lowest return profiles and highest percent negative ratios across the 115 sectors, subsectors, and style factors we model within the US equity market. 

When I created the GIP Model 7-8 years ago, I was only trying to help myself better distill, contextualize, and communicate relevant top-down signals from the chaotic system that is the global economy. It wasn’t until I started rigorously backtesting financial market history through this handy lens that I realized how valuable this tool can be for investors. For example, if you’re a siloed Financials-only PM, you’ll be pleased to note that Insurance Brokers have historically been one of the best places to hide in #Quad3, not only within Financials, but also within the broader market as well. 

For those among you who prefer to view the world through a bottom-up lens, #Quad3 = sales slowing, margins compressing. Ask Uber CEO Dara Khosrowshahi who is going to learn what #Quad3 means to his business when he tries to price a $120 billion IPO this year after sales growth slowed from a cycle-peak of +38% YoY in Q3 to +25% YoY in Q4 and its take rate declined sequentially in Q4 – all amid its fast-growing competitor Lyft gobbling up 29% of the ride-sharing market last year. 

Heck, even our business had its own #Quad3 moment last year after MiFID 2 gave every large asset manager an excuse to indiscriminately cut commissions. But after weathering the storm and refocusing our efforts on our core subscription businesses and core business partners, we’re poised to diverge from the broader financial services industry en route to a multi-quarter run of #Quad1 after @Hedgeye sales growth inflected in late-2018. 

Who knows, maybe by this time next year my PA trades will be big enough to be worth mentioning regularly… 

Our immediate-term Global Macro Risk Ranges are now: 

UST 10yr Yield 2.60-2.71% (bearish)
UST 2yr Yield 2.43-2.54% (bearish)
SPX 2 (neutral)
VIX 13.77-18.87 (neutral)
USD 95.95-97.15 (bullish)
Oil (WTI) 51.26-58.43 (bullish)
Gold 1 (bullish)

Keep your head on a swivel,


Darius Dale
Managing Director

Short the Financials - Chart of the Day

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