Stocks Rebound Modestly
After a terrible week and a bad run for the bank stocks, the market finally rallied on Thursday. I expected this rally since the CNN Fear and Greed index showed the market was oversold. Interestingly, the Dow’s decision to replace GE with Walgreens was a big mistake in the near term. GE stock is up 8.47% since Monday’s close and Walgreens was down 9.9% on Thursday, hurting the Dow’s performance. The Dow still managed to eke out a 0.41% gain. The S&P 500 was up 0.62% and the Nasdaq was up 0.79%.
Stress Tested Banks Rally
The bank stocks did well as the financial sector in the S&P 500 was up 0.86%. On Thursday, the Fed released its stress tests of the banks which tells them whether they can increase their capital returns because they have solid enough balance sheets. Morgan Stanley and Goldman Sachs had a temporary issue which hurt their ability to return cash to shareholders because their capital ratios fell as a result of the tax cuts. Some of the banks needed to pay extra taxes in preparation for the new tax code at the end of last year.
These two banks fell beneath the minimum required ratios for capital levels called tier 1 leverage and supplementary leverage under a scenario of financial distress. The regulators gave them conditional non-objections to their capital plans. Goldman is going to pay out $6.3 billion starting in Q3; it is raising its dividend 5 cents to 85 cents. Morgan Stanley is giving out $6.8 billion which is the same as last year. It’s raising the dividend from 25 cents to 30 cents. Morgan Stanley was up 2.33% and Goldman Sachs was up 1.46% on the day.
The stress tests results were released after the close, so we need to look at the after hours action to see how they effected the stocks. Both Morgan Stanley and Goldman Sachs were flat after hours. The XLF ETF was up about 0.71% after hours, meaning those two firms underperformed. The bank sector should be up on Friday. State Street was given a conditional non-objection as well; it was asked to improve its management of counter-party risk.
Those issues with Morgan Stanley and Goldman Sachs were temporary, but Deutsch Bank faces real issues which need to be reviewed. Deutsch Bank was named a troubled institution because it has poor management of data, poor capital plans, and it forecasts losses and low revenues. Its stock was down marginally after hours. It has had disastrous performance in the past year as it is down 42%. The stock is down below the lows during the financial crisis and is about to reach single digits.
The stress test was very intense. The assumptions put in the stress test include a 7% decline in GDP growth, a 10% unemployment rate, and stocks down 65%. The losses put in the stress test are 7 times the current losses. These tough stress tests should make investors and consumers who use these too big to fail banks feel confident. It’s unlikely that the banks will run into the scale of issues seen in the financial crisis again because there are tougher lending standards for mortgages, but now we know if there is another crisis, the banks will be fine.
Sector Performance
Most sectors were up because it was a risk on day. Telecom and tech did the best as they were up 2.29% and 1.08%. The utilities were down 2 basis points and energy were down 12 basis points. Obviously, it’s easy to be bearish with the market falling quickly, but one thing which should keep the market from plummeting is the increasingly positive earnings revisions. As you can see from the table below, the estimates for Q2, Q3, Q4, and Q1 all moved up this month. It’s interesting to see the sharp fall in Q1 estimates from March 1st to June 1st. That may have led to the volatility this year.
Steepening Curve
I would like to see the banks rally without the curve steepening because I think the curve will likely flatten for the rest of the year. That being said, bank investors will take whatever they can get as the sector was down 13 days in a row. The 10 year yield rose about 1 basis point to 2.8365% and the 2 year was flat as it as at 2.5161%. The latest difference between the 2 yields is 32 basis points.
Dollar Hurting Earnings
When firms start reporting earnings at a faster clip next month, they will be complaining about the higher dollar. Sometimes complaints are unjustified because firms like to blame temporary issues for their structural problems, but it is true that a strong dollar hurts international profits. As you can see from the chart below, the inverted year over year performance in the dollar is correlated with the year over year change in operating EPS. The 5% year over year dollar performance is expected to cause EPS growth to be negative. Since the tax cuts are helping earnings, I doubt that expectation will be realized, but it is food for thought.
Yield Curve Fine For Now
I have previously explained that the stock market usually does well when the 10/2 yield curve is in between 50 basis points and 0 basis points. However, it’s worth repeating because some investors are panicking because of the recent sharp flattening. As you can see from the chart below, the average performance in the past 4 flattening periods shows annualized gains of 14.3%. The period from 1997 to 1998, might not be repeated, but each period saw gains.
Conclusion
Stocks are dealing with a few countervailing factors. The rising dollar, tightening Fed, and trade tensions are hurting them, while rising earnings estimates are helping them. This explains why the market has been range bound for the past few months. If you’re bullish, you can say the estimates are rising despite those woes and if you are bearish you can say the negative catalysts aren’t in the analysts’ numbers.
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