Banks To Rally As The Fed Accepts Capital Return Plans

The big news on Wednesday afternoon was that the Federal Reserve didn’t have a problem with any of the 34 banks’ capital return plans. You can look at this as a positive or a negative. It’s clearly a positive for the near term because it means dividend and buyback increases for the banks. The XLF financials ETF rallied 1.63% in after hours trading. JP Morgan (JPM) is raising its dividend to $0.56 from $0.50 per quarter and has authorized $19.4 billion in buybacks by June 30th, 2018. Citigroup (C) raised its dividend to $0.32 and has $15.6 billion in buybacks authorized through Q2 2018. The reason this news could be considered a negative for stocks is because it could be a signal that the Fed is serious about normalizing rates and the balance sheet, since it’s relaxing its concerns for the banks. If the Fed has an agenda for hawkishness regardless of what economic data is released, it could lead to a recession sooner than later.

The chart below shows that, while the Fed was worried about the banks offering big dividends to shareholders, the Fed has created one of the most overvalued stock markets ever. The banks only lent money to unqualified buyers during the housing bubble because the government demanded them to because it thought owning a house was part of the ‘American dream.’ The point I’m making is that the banks can decide what’s right without the Fed stepping in.

Instead of Yellen saying she’s concerned with asset valuations, she should have not gone through with the QE policy to create the bubble in the first place. Critics of those who are skeptical of Fed interventionism say that we’re not allowed to express worry about raising rates because we’ve wanted the Fed to raise rates for years. That’s a false equivalency because I disagreed with the past 7 years of policy and am now simply warning about the potential effects of normal policy.

Stocks Will Underperform In The Long Run

The chart reinforces a point I’ve made earlier. The worry about the stock market isn’t that the top 5 tech stocks have too much weighting. The worry is that the overall market is overvalued. As you can see, compared to the peak of the most expensive bull market in history, every category of stock valuations, besides the most expensive category, have higher forward PEs. The cheapest stocks in the first quintile have a forward PE of 10.8 compared to only 7.6 in March 2000. There are less places to hide in this bull market than in the tech bubble. To be clear, I’m not saying that the most expensive stocks are great buys. However, the market isn’t any more top heavy than usual. It’s bottom heavy.

Adding to the point about stocks being overvalued, the chart below shows the S&P 500’s price to sales ratio and forward price to sales ratio are near record highs. The S&P 500 is up above 3% in Q2. According to FactSet, S&P 500 revenues are expected to increase 4.9% in Q2 which means the price to sales ratio will fall slightly. Meeting the most expensive market ever isn’t a place you want to be if you’re a bull.

Even though valuations look crazy expensive, this isn’t stopping Goldman Sachs (GS) and Oppenheimer (OPY) from raising their year-end price targets for the S&P 500 because they need to chase the market. There’s no rule that you must raise your price target if the market exceeds the target before the year ends. You need to have belief in your initial analysis to maintain a price target. Clearly, these banks don’t have that. Oppenheimer’s previous price target was 2,450. They promised to raise their target in the next few days. Goldman Sachs raised its price target from 2,300 to 2,400. I find their logic to be poor as they said they raised their S&P 500 margin forecast because of great Q1 economic data, strong technology margins, and a rebound in energy margins. Firstly, the economic reports in Q1 weren’t better than expected as Q1 GDP growth was 1.2%. Secondly, the energy margins were always expected to grow. In its previous estimate, Goldman already knew margins would expand. If anything, the margin expectations should fall because oil prices have fallen in the past few weeks to the low $40s.

The Bullish Case

To be clear, I’m not saying stocks are going to fall immediately. As you can see from the chart below, despite the Fed raising rates 3 times, the financial conditions have become looser. This is supported by the ECB bond buying which has caused European corporate bonds to have their lowest bond yields ever. It shows how the Fed funds rate isn’t as important as it once was. This may be because of QE taking precedent. I think central banks setting interest rates has more of a local effect while QE has a global effect because when the ECB lowers corporate yields in Europe by buying corporate bonds, money flows to America to chase its higher yields. Also, part of the ECB bond buying includes buying some bonds in America, so obviously that will have a more direct effect than what they set their near-term interest rate at.

To add to the bullish case, tax withholdings are up 6.25% in May 2017 from May 2016. This means people are making more money this year. The tax withholdings are up more than wage growth which is positive. By the time the first month of tax withholdings are down, if it’s not caused by a one-time event, stocks will already reflect the weakness. It’s not a leading indicator.

Another positive is that the difference between the 10 year yield and the 2 year yield is expanding which means the yield curve is steepening. The difference is now 87 basis points which means there has been 8 basis points of steepening. I have predicted stocks would fall 10% if the difference fell to below 75 basis points, which was the low in 2016, but that flattening never occurred, so the prediction still holds.

Conclusion

Stocks should rally to new all-time highs on the back of the financials increasing their returns to shareholders. The near-term good news is tax withholdings are up, financial conditions are loosening, and the yield curve is steepening. My outlook for the next 10 years is as bearish as it can possibly be as valuations are as high as 2000 on a price to sales basis. On a price to earnings basis, the market looks slightly better. The reason I criticize Goldman and Oppenheimer is they do mostly good analysis, but then fiddle with the inputs to get a desired result. That result is higher because stocks are up.