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Brexit Breaks the Banks

The common stock of the European Banks is getting crushed in this post Brexit selloff.  Our own S&P 500 is holding up better on a relative basis.

SPX 2016-06-27

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The graph above is the one you have seen here on the blog a few times before.  It shows the S&P 500 Index for the past 18-months and how it has primarily traded in a 4% range during that time.

There are two important points to note on this graph before we look at the banks:  (1) the index has dropped below the bottom of the trading range in a definitive way; and (2) the index is sitting right on two major support levels – (a) the market closed today with the index at 2,000.35, virtually sitting on the psychologically important 2,000 level; and (b) after an intraday low of 1991, the market recovered above the 1998 level of the lower support as defined by the previous month’s trading activity.

With the S&P 500 down about 2% year-to-date, our market is not in a free fall.  If you don’t know what a free fall looks like on a chart, look at Barclays Bank:

BCS

And, how about Lloyds of London:

LYG

And we can’t ignore Royal Bank of Scotland:

RBS

These banks are off double digit percentages each of the past two trading sessions.  They trade for roughly 30% of book value.  This is a BIG warning sign that there is something really wrong in the global banking system.  The British banks are being hit by investors, but if you look at any of the other big European banks you will see that they have also sold off in a significant way, maybe not as bad over the past two days, but over the past year many of the most leveraged ones are down 50%.

The US banking system is far healthier than its European counter-part.  The banks here have significantly more capital and significantly less leverage.  That’s not to say that if there is a European banking crisis and the governments there have to inject capital to keep the banks afloat that it won’t impact our banking system – it will, the world is way to interconnected and most of the big banks are involved in complicated derivative contracts in the Trillions of dollars which are off balance sheet but a contingent liability none the less.  If even one bank goes down and cannot make good on its counter party obligations, the impact will be felt globally (if you haven’t rented the movie The Big Short, you should to get a flavor for what this could potentially look like if not managed correctly by the banks and the European governments).

As always, I have an indicator that has served me well beginning with the 1987 stock market crash which was caused by a disruption in the global financial markets, the TED Spread.  This TED Spread graph plots the difference between US Treasury yields and Eurodollar deposit yields.  As the spread increases, it indicates that investors perceive there is increased risk in dollar denominated deposits in European banks and require a higher return.  Back in 1987, the spread got to over 200 basis points.  During  the 2008 crash, it approached 475 basis points.  Today, it is sitting around 39 basis points, but up from 11 basis point at its low in 2010.

TED

If we start to get a sustained move higher, that will be a sign that there is something seriously at risk in the global financial system – which will be a sign that its time to get very conservative in portfolio management.  For now, the steady trend higher, albeit still at low levels, causes us to keep track of this indicator as a prudent risk management practice.

But lets take a look at our top graph again, except this time I’ve added two short-term directional indicators to give us an idea of what might happen tomorrow:

SPX 2016-06-27 v2

The bottom two panels of the above image are the Relative Strength Indicator (RSI) and the Stochastics.  Both flash reversal signals when the indicator line drops below the bottom horizontal line.  You can see that the RSI (upper most of the two panels) is sitting right on the line and the Stochastics (bottom of the two panels) is still well above that line and falling.

If both were above the line and falling, it would indicate that we would likely have another down day in the market tomorrow.

If both were below the line it would indicate that the market is getting ready to turn higher – even if for just a short term bounce.

However, with neither one below the line but one sitting on it, you have a less than 50% chance that the market bounces higher tomorrow.

In spite of the odds, I have more than a feeling after having worked with this stuff for 35 years that we could bounce higher tomorrow, particularly since the index ran higher off the lows at the end of the day. The computers kicked in their buy programs when the market hit a triple bottom for the day which was a level that the index bounced higher from the previous two times (below is the chart of just today’s action on the index):

spx today

The overnight news will determine much of how we open tomorrow – it will be day three since the Brexit, so the media are getting tired of reporting on the same thing and will be looking for new news to make.  So absent another day of chicken little news casts, and if we get some stability in prices in Europe over night, our own markets should see some buying and bounce higher.  If there is more bad news, it will likely continue to fall.

Remember, invest what you see and not what you believe is our golden rule here on the blog.  We will see what tomorrow brings us and make investment decisions accordingly.

Mark