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This Troubling Disparity Says Financial Crisis Could Become Reality Lombardi Letter 2020-11-10 01:59:43 financial crisis bank stocks stock market There’s a divergence happening between the overall stock market and bank stocks. Does it mean there could be a financial crisis right around the corner? Here are the details. Analysis and Predictions https://www.lombardiletter.com/wp-content/uploads/2020/11/hand-and-wooden-block-with-falling-arrow-XCKPE6Z-150x150.jpg

This Troubling Disparity Says Financial Crisis Could Become Reality

financial crisis

Bank Stocks Underperform: Indication of Financial Crisis?

A financial crisis could be right around the corner. Investors beware.

You see, when there’s euphoria on the stock market, investors become complacent and think the good times will go on forever. I can’t stress this enough: don’t get complacent when almost everyone is bullish and those who preach caution are mocked.

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Sadly, as it stands, there are some signs suggesting that wealth destruction of some sort could be in the making.

Digging into the details…

To figure out if a financial crisis could be ahead, you have to look at the banks. At the moment, on the surface, everything looks great for banks. If you look at their income statements, you’ll see them making a lot of money. Plus, earlier this year, the Federal Reserve said it would do whatever it takes to keep liquidity going.

Keep in mind, a financial crisis happens when liquidity in the financial system dries up. The Fed has made it very clear that it will ensure that this doesn’t happen.

However, the market says something else. In particular, the performance of bank stocks has been dismal.

Look at the chart below. It plots the performance of the S&P 500 and the Financial Select Sector SPDR Fund (NYSEARCA:XLF), an exchange-traded fund that tracks the performance of the major U.S. banks, for the past year.

Chart courtesy of StockCharts.com

U.S. banks are significantly lagging behind the overall stock market. One would assume that they would be surging in value since the Fed has provided them with a sort of insurance and their financial performance looks great on the surface.

In the past year, the S&P 500 has jumped by more than 12.5% while U.S. financial stocks have fallen by more than 13%. That means banks are underperforming the S&P 500 by roughly 25%.

A Financial Crisis Won’t End Well

Dear reader, the divergence between bank stocks and the broader stock market is very concerning. At its core, this divergence says there’s some stress in the financial sector. If the stress remains for a long period, many problems could follow, even a financial crisis.

Let me be very clear: I’m not rooting for a financial crisis. I’m just pointing out something that the mainstream media and pundits haven’t been discussing.

The help that the banks have gotten from the Fed may not be enough. In fact, it wouldn’t be wrong to say that the banks may be in too deep for the Fed to really help them.

As of the second quarter of 2020, the top 25 banks had $179.0 trillion notional worth of derivatives. (Source: “Second Quarter 2020: Quarterly Report on Bank Trading and Derivatives Activities,” Office of the Comptroller of the Currency, last accessed November 9, 2020.)

Here’s the kicker: the vast majority of these derivatives were tied to interest rates. Imagine what will happen if there’s a shock in the interest-rate market and just five percent to 10% of the derivatives go bad. The outcome could be devastating.

The divergence between bank stocks and the overall stock market tells a very scary tale. And if a financial crisis follows, it won’t end well. A lot of wealth could be wiped out.

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