The only trade that matters

Good morning. French turn! The tactical withdrawals of candidates from the centre and the left have forced the right to third place in the second round of the French national elections. The right was expected to finish in first place, perhaps with a absolute majorityPolitics, like markets, is a dynamic system full of unexpected feedback loops. Pontificate with care! Email me at: robert.armstrong@ft.com

The Omnitrade

In the WSJ, Jason Zweig has… he pointed that active fund managers are even underperforming their benchmarks:

[In] In the first half of 2024, according to Morningstar, only 18.2 percent of actively managed mutual funds and exchange-traded funds that benchmark against the S&P 500 managed to outperform it.

By comparison, over the past ten years, the figure was 27% (why are people holding actively managed funds again?). The reason, Zweig continues, is that more than half of the S&P’s returns have come from a few huge stocks. Nvidia, Microsoft, Lilly, Meta and Amazon accounted for 55% of the returns in the first half of the year. Meanwhile, the five largest stocks in the index (Microsoft, Apple, Nvidia, Alphabet, Amazon) account for 27% of the index’s total value. For most active managers, having, say, 20% of their fund in three stocks is a risk-limit violation; you’re no longer diversified in any recognizable sense. But if you don’t have that much exposure to the largest stocks in the index, you’ve almost certainly underperformed.

To put it bluntly: the options are (a) make a big bet that Big Tech’s hot streak will continue, or (b) risk losing investors’ assets, followed by their jobs. This isn’t just a problem for stock pickers. Wall Street strategists are in the same bind. From the FT last week:

Marko Kolanovic is stepping down as JPMorgan’s chief global market strategist, ending a 19-year tenure that culminated in a series of ill-timed decisions on the U.S. stock market.

Kolanovic… was among the few remaining bearish strategists on Wall Street, having recently forecast that the S&P 500 would fall nearly 25 percent from its current levels by year-end…

Two years ago, it advised clients to take an overweight position in U.S. stocks during the market’s sharp decline, before moving to recommend an underweight position in early 2023. The bank has stuck to that position ever since, even though the blue-chip index has risen more than 40 percent since then.

The FT article, and others like it, don’t provide details on why Kolanovic is leaving, but it seems possible that incorrect directional predictions in the market have driven him out. If so, he was caught in the dilemma Zweig describes. Either you insist that “the AI ​​market” (as Unhedged has put it) call it) is stable and sustainable, or you’ll look like a fool. But this insistence requires you to turn your back on many of the standard principles of fundamental analysis and portfolio design.

Kolanovic, who acted as the standard-bearer for these principles, came out in full force. The mid-year outlook from JPMorgan Global Research, of which he was the lead author and which was released just a week ago, made a strong case that the current market regime is dangerously unstable. The key points:

• Momentum trades are massively crowded

• Most of the returns are concentrated in a few mega-cap stocks.

• To maintain momentum, megacaps will need to continue to outperform consensus estimates.

• These estimates encode expectations of double-digit growth for the foreseeable future.

• Year-over-year earnings comparisons will be more difficult in the second half

• Investors are already aggressively positioned in stocks and sentiment is bullish

• The business cycle is moving sideways at best, with the low-end consumer under pressure.

• Rapid rate cuts are unlikely, and even if they occur, the long end of the curve (which is the discount rate for risk assets) could remain high.

• The impact of buybacks is fading

• Money supply growth is weak

• Interest expenses are increasing

• Valuations are at cycle highs

• The risk premium on shares is very low

• Volatility is unsustainably low

“Hyperbolic moves in price and sentiment tend to correct violently more often than not when exuberance runs its course,” the report sums up. If Kolanovic knew the walls were closing in on him at JPMorgan, then he presented himself in his latest report as an unfair and very clever scapegoat in case there was a market reversal in the second half of the year. Even if there wasn’t, one can respect his courage in embracing the unpopular side of binary trading that is the current US stock market.

Regional banks vs. big banks

The fortunes of major banks and regional banks have diverged significantly over the past five months:

The reasons for this are fairly well understood:

1. Regional banks tend to have greater exposure to the commercial real estate sector, which is under pressure from higher-for-longer interest rates.

2. Deposit costs at larger banks, which are perceived as safest, have risen less as rates have increased than those at smaller regional banks.

3. Hopes have been raised that Basel III banking standards will be watered down, which is a boon for big banks but no big deal for smaller ones.

4. Fee businesses where larger banks are strong, such as commercial and investment banking, have performed well.

However, if we accept all this, it is a historical fact that the ratios of the big banks and those of the regional banks do not move too far apart for too long. Here is a 20-year chart:

One argument for why the two follow each other might be this: banking is a spreads business: banks acquire money at one price and supply it at another. And money is a commodity: over time, its acquisition and provision prices will tend to be the same for most banks, because they are determined primarily by macroeconomic rather than idiosyncratic factors. Some banks are better-run businesses than others, of course, and will outperform the rest. But take two reasonably large groups of banks – large or small – and they will follow each other closely. If that is right, perhaps we could expect the gap between the big banks and the regional ones to close eventually.

The KBW Bank Index includes not only large financial center banks, but also super-regional banks such as US Bank, Truist and PNC. The recent divergence is even more extreme when comparing financial center banks to the regional index. The gap is about 30 percentage points since the end of January:

It is interesting to observe this last relationship since 2016 (I choose that date because before that date the recovery from the financial crisis still confuses the signals a bit):

The pattern here is that the two largest and most diversified US banks, JPMorgan Chase and Bank of America, rise strongly and dominate Citi, Wells Fargo and the regionals, which move more or less sideways most of the time. But two things have changed more recently. First, starting in early 2023, JPMorgan pulled ahead of BofA, presumably due to its decision to keep its most liquid assets in short-duration assets in anticipation of higher rates. BofA’s failure to do so led to many billions in unrealized losses. Then, Citigroup and Wells have had a great 2024; both banks seem to be recovering from a pretty serious institutional mess over the past decade or two.

This leaves some interesting questions. Have technology, strong regulation, or some other factor made banking economics different and better for the larger, diversified banks, a category that currently includes only JPMorgan and BofA? If so, could Citi or Wells or one of the superregional banks join that category? And if so, could they do so? No So is it ever worth betting on the return of a regional bank?

A good read

About him meanings in emphasis.