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How Oversold Are Regional Bank Stocks?
Bargain basement prices won't last long
US blue-chip equities are the premier risk asset of the world. This is the most contested corner of global financial capitalism. If prices are not efficient here, they can scarcely be expected to be efficient anywhere else. Markets are efficient to zeroth order in that prices do not usually get very far away from economic fundamentals. Investor panic and, more generally, herd behavior can drive prices away from reasonable values for some time. But sooner or later such sentiment-driven fluctuations reverse. The fluctuations that are most easily reversed are those relating to the relative value of roughly interchangeable assets.
When noise traders drive prices far from fundamentals, informed arbitrageurs increase their contrarian bets. In order to do so, they need access to dealer balance sheet capacity. When balance sheet capacity is scarce, arbitrageurs cannot get all the leverage they want and many economically reasonable wagers do not get placed. The literature that studies this goes under the rubric of “limits to arbitrage.”
There is another species of investor that becomes relevant in a fire sale. These are patient investors like pension funds with deep pockets who are starved of yield. They’re leverage-constrained by their mandates, they try to get around it by investing in private assets. But when an important corner of the premier risk assets gets dramatically oversold, they face very strong incentives to swoop in and buy said risk assets at fire-sale prices. Patient investors therefore act as buyers of last resort—when intraday liquidity providers and alpha-seeking hedge funds leave money on the table for long enough, they come in. Although, they do move slowly.
The market capitalization of US blue-chip equities has fallen 15.6% from the peak. Financials are down 26.0%. Financials have a market beta of 1.29, so this is not altogether surprising since the CAPM-implied return is already 20.1% (1.29 times 15.6%). Now, the beta of the market-weighted portfolio of regional bank stocks is 1.22. So, the CAPM-implied return for them is 19%. But they’re down 50% from peak!
YTD returns of market-weighted portfolios tell the same story. As of today’s closing auction, the market as a whole is up 6.3% year-to-date, Financials are down 6.8%, and regional bank stocks are down 34.0%. Most of this decline took place in March, and then this week. Regional bank stocks fell 24.8% in March. They’ve already fallen by 16.6% this week.
This week has been particularly brutal for all longonly investors. But the mark-to-market losses for investors in regional banks have been especially nasty—4% on Monday, 6% on Tuesday, 3% on Wednesday, and another 5% today. If market pricing is correct, then we’re in the midst of a major episode of bank distress in the United States. But does that add up?
I decided to look under the hood at the balance sheet and income statements of the regional banks in order to better understand whether this is a market panic—perhaps driven by Jamie Dimon’s unfortunate comment about there being one more to go—or whether the dramatic repricing is justified by economic fundamentals.
Standard multiples for regional banks are now at levels last seen during the peak of the Covid crisis in the Summer of Rage. In the following graph, I’ve rescaled the three multiples (price-to-book, price-to-equity, and price-to-sales) to range between zero and one, so that we can visualize in the same graph.
The market-weighted price-to-book ratio for regionals was already down to 76% of peak by March 1. By today’s close, it’s down to 47% of peak. Price-to-equity ratios were down to 58% of peak by March 1; now, they’re down to 37% of peak. Finally, price-to-sales were down to 66% of peak before the banking panic. They’ve now fallen to just 42% of their peak values. Again, over the past decade, the only point of comparison is the summer of 2020.
These regional banks are not old school firms losing business to newer, more sophisticated rivals. They remain economically profitable. Their profit margins may have retreated from the 2021 peak. But they remain high by historical standards.
These total revenue has never been higher and has been growing above trend. We expect this to temper as Powell does his job. But these are hardly businesses in distress.
Their total profits show the same reassuring “up and to the right” pattern.
Their net operating income is robust.
And it is largely hard cash; not accounting gimmicks.
Finally, whatever one thinks about the future profitability of American banks in light of where we are in the monetary cycle and the uncertain macro outlook, note that these affect regional banks and G-SIBs similarly. JPM and FHN are in the same boat when it comes to net interest margins. And whatever you may think about how bank stocks should be valued relative to risk assets as a whole, within the banking sector, it is not clear why regional banks are expected to underperform G-SIBs. For while it is true that the latter enjoy more explicit state guarantees, they also face stronger supervision and more onerous regulatory burdens. This is not a winner-eat-all business. There’s space for both regionals and megabanks in the US economy.
Not only are all banks essentially in the same business and subject to similar macro risks, there’s an extremely strong empirical correlation between their stocks. The correlation coefficient for the daily returns of market-weighted portfolios of regionals and G-SIBs since 2016 is 0.93. The two portfolios are so tightly coupled that they provide excellent hedges for each other. Indeed, this anomaly must’ve come to the attention to specialists in statistical arbitrage. At any rate, any quant will look at this and say: there better be a good reason why these two graphs have diverged suddenly. Unless there is a very good economic reason—not narrative, but real money—this has all the makings of an excellent contrarian trade.
If arbitrageurs won’t do it, patient investors will eventually step in to scoop up the oversold assets. The bargain basement prices won’t last forever. Sooner or later, the panic will ease. And those holding these stocks will make a killing.