Can’t we just ignore bank stocks when this happens? I mean maybe they just slept in or had a bit too much to drink the night before and well you know. We can but the track record for ignoring weakness in the financial sector has never worked out well. Best to try and determine what might be happening under the surface. I remember back in late 2007 when a mortgage company went under and the initial reaction from Wall St. equated to a big yawn, calling it an “isolated” incident. Then another mortgager went under a month or two later and by the Spring of ’08 the United States economy was in a heap of trouble. A recession ensued so deep across the country that it is referred to in the record books as “The Great Recession”.

This time the backdrop is a bit different. I do not think we have a scenario like that in front of us but understand something, there are two sectors that serve as great barometers for the overall health of the U.S. economy and those are financials and transportation. When stocks in these two sectors are underperforming it bodes poorly for any upcoming expansion plan. The short answer translates to something is wrong. Sometimes what is wrong is hidden from view [for a time], such as was the case in late 2007. Symptoms show up first before any actual disease gets identified. That’s always the case and usually lawmakers in Washington will try and stop the leaks in the system to prevent any further contagion, that’s their typical response anyway. They’ll try using a band-aid to cover a gushing leak in the dam when in actuality no federal stimulus program can fix it. Instead, the forces of demand and supply along with the government getting out of the way those are the only permanent solutions for what ails the economy really every time. But yet they’ll meddle anyway where they’re not wanted. Lawmakers in Washington don’t mind people suffering financially it’s just that they don’t want it happening on their own watch, it tends to harm their chances of re-election. See now?

During real bull markets everyone becomes a genius at investing and we can tend to forget something, the business cycle remains alive and well through it all. In the case of a downturn in the economy it’s the business cycle that must return to health before any ships get righted. When bank lending is shrinking [for any reason] and loan loss reserves are climbing that should send off alarm bells that things are not copacetic. There’s a repeatable pattern that plays out in these scenarios. The pattern being that early warning signs have a tendency to be ignored at first. It’s not until the destruction hits home that ginormous economic woes make the headlines but by then it’s too late for many. Those that were long in stocks and/or fully invested, those are the ones that get punished the most.

The current scenario began when the yields – the spread difference between the 2-year and the 10-year treasury inverted. Most people yawned it off then and still ignore it today but not me. This bond yield inversion, one of the best indicators ever of an impending recession, happened almost two years ago now. I believe the month was either late October or early November of 2021 and I noticed it was followed by some net selling of stock positions. I was one of those who began to liquidate some positions on the news. Of course fast-forward and the stock market was crashing only six months later [into 2022]. However, inflationary pressures still persist but no “official” recession to claim other than a couple of barely negative quarters, so what is going on? Answer: federal stimulus programs have kept the patient on life support like no other time in our history, that’s what is happening out there.

So where do we go from here? No doubt about it there’s a ton of moving parts out there. Large banks, small banks and banks in-between will find it more difficult to lend under an inverted yield curve scenario. The reason being that depositors are seeking a return on cash deposits so they’re parking money in short-term instruments – treasuries, high-yielding [fancy-smancy] money markets and CD’s in order to get something, any positive return over inflation. Meanwhile, that can tie up some capital that would have been available for banks to loan out. Meanwhile, in order that loan rates stay competitive bank underwriting standards must increase because they are now being squeezed [between a rock and hard place] as they confront shrinking net interest margins on the spread [or the difference between what they must pay depositors and what they can earn from lending].

What’s the most likely outcome? Should rates continue to rise [over time] or at least stay firm sophisticated investors will begin to move more money [out of the stock market and] into fixed income instruments. This will happen for a couple of reasons, bonds can offer competitive returns with lower risk especially in a maturing inflationary environment. Bond yields become very attractive around 5%+ on very short term paper and even higher for intermediate-term maturities. History can attest that yields at these levels can be more attractive than taking on stock market risk. Once short to intermediate term yields [on quality paper] reach 8% or above, all bets are off. Significant money will then leave the stock market and shift into fixed income instruments. This phenomenon is what eventually caused the 1987 Stock Market Crash. I was @ Smith Barney at the time and saw it with my own eyes. Looking back it made so much logical sense yet few saw it coming… that’s how most market crashes work, few will see them coming. 😉

Warning: If the U.S. economy continues to operate under rising inflation [coupled with the over-regulations that cause supply chain constraints] plus continue on this path of fiscal irresponsibility it will surely place more pressure on rates to rise further and eventually [under this same scenario] it’s highly likely that we will see a remake of the stock market crash of 1987.