The only trade that matters

Good morning. French twist! Tactical candidate withdrawals by the centre and left have forced the right into third place in the second round of French national elections. The right were once expected to finish first, perhaps with an outright majority. Politics, like markets, is a dynamic system full of unexpected feedback loops. Pontificate carefully! Email me: robert.armstrong@ft.com

The Omnitrade

Over in the WSJ, Jason Zweig has pointed out that active fund managers are underperforming their benchmarks by even more than usual:

[In] the first half of 2024, according to Morningstar, only 18.2 per cent of actively managed mutual funds and exchange traded funds that compare themselves to the S&P 500 managed to outperform it

That compares to 27 per cent over the past 10 years (why do people own actively managed funds again?). The reason this is so, Zweig goes on to say, is that more than half of the returns in the S&P come from a few huge stocks. Nvidia, Microsoft, Lilly, Meta and Amazon accounted for 55 per cent 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 per cent of the total value of the index. For most active managers, having, say, 20 per cent of your fund in three stocks is a violation of risk limits; you are no longer diversified in any recognisable sense. But if you don’t have that much exposure to the biggest stocks in the index, you have almost certainly underperformed.

To put it more bluntly: the options are (a) make a huge bet on big tech’s great run continuing, or (b) risk losing investor assets, followed by your job. This is not just a problem for stock pickers. Wall Street strategists are in the same bind. From the FT last week:  

Marko Kolanovic will leave his role as JPMorgan’s chief global markets strategist, ending a 19-year stint that culminated in a series of mistimed calls on the US stock market.

Kolanovic . . . was among the few bearish strategists left on Wall Street, having recently forecast that the S&P 500 would tumble by almost 25 per cent from current levels by year-end…

Two years ago he advised clients to take an overweight position in US stocks during the deep market sell-off, before switching to recommending an underweight position in early 2023. The bank has stuck with that position ever since, despite the blue-chip index having surged more than 40 per cent since then

The FT’s piece, and others like it, doesn’t provide specifics about why Kolanovic is leaving, but it sure seems possible that the incorrect directional calls on the market got him pushed out. If so, he was caught by the dilemma Zweig describes. Either you insist “the AI market” (as Unhedged has called it) is stable and sustainable, or you look like a dope. But this insistence requires you to turn your back on a lot of the standard principles of fundamental analysis and portfolio design. 

Kolanovic, acting as the standard-bearer for these principles, went out guns blazing. The JPMorgan Global Research mid-year outlook, of which he was lead author and which came only a week or so ago, made a table-banging 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 megacap stocks

• To keep the momentum going, the mega-caps will have to keep beating consensus estimates

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

• Year-over-year earnings comparisons will get harder in the second half

• Investors are already aggressively positioned in equities, and sentiment is bullish

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

• 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 stay high

• The impact of buybacks is fading

• Money supply growth is weak

• Interest expenses are rising

• Valuations are at cycle highs 

• The equity risk premium is very low

• Volatility is unsustainably low

“Hyperbolic moves in price and sentiment are more often violently corrected than not when the exuberance runs its course,” the report sums up. If Kolanovic knew the walls were closing in on him at JPMorgan, then he set himself up in his last report to look very clever, and unfairly scapegoated, if there should be a market reversal in the second half. Even if there is not, one can respect his courage for taking the unpopular side of the binary trade that is today’s US stock market. 

Regional banks vs big banks

The fortunes of big banks and regional banks have diverged in a big way in the last five months:

The reasons for this are reasonably well understood:

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

2. Deposit costs at the largest banks, which are perceived as the safest, have risen less as rates have increased than those of smaller regionals 

3. Hopes have risen that the Basel III banking standards will be watered down, which is a boon to big banks but does not matter to smaller ones

4. Fee businesses where the bigger banks are strong, such as trading and investment banking, have been doing well 

Accepting all that, though, it is a historical fact that the large bank and regional bank indices do not move too far apart for too long. Here is a 20 year chart:

An argument for why the two track each other might run as follows. Banking is a spread business: banks acquire money at one price and provide 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 mostly by macroeconomic rather than idiosyncratic factors. Some banks are better-run businesses than others, of course, and they will outperform the rest. But take two reasonably large group of banks — large or small — and they will track each other pretty closely. If that’s right, perhaps we might expect the gap between the big banks and the regionals to close eventually. 

The KBW bank index includes not only the huge money-centre banks but also super-regionals such as US Bank, Truist and PNC. The recent divergence is even more extreme if you just compare the money centre banks with the regional index. The gap is about 30 percentage points since the end of January:

It is interesting to look at this last relationship going back to 2016 (I pick that date because before then the recovery from the financial crisis still scrambles the signals a bit):

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

This leaves some interesting questions. Has technology, heavy regulation or some other factor made it that banking economics are different and better for the very largest diversified banks — a category that currently includes only JPMorgan and BofA? If that is so, might Citi or Wells or one of the super-regionals be able to join that category? And if it is not so, is it at some point worth betting on a regional bank comeback?

One good read

On the meanings in emphasis.

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