The Market Mosaic 4.30.23
Will First Republic reignite the bank crisis?
Welcome back to The Market Mosaic, where I gauge the stock market’s next move by looking at macro, technicals, and market internals. I’ll also highlight trade ideas using this analysis.
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Now for this week’s issue…
With over 40% of the S&P 500’s market capitalization reporting earnings, including corporate behemoths like Microsoft and Amazon, last week was packed full of catalysts.
But it’s what happened after the market closed out the week that might be the most important event.
After dropping 78% just last week (see the chart below), it was announced on Friday evening that First Republic Bank (FRC) would be placed into receivership by the FDIC. In other words, FRC became the next casualty of the bank crisis that emerged in March…and which apparently hasn’t gone away.
FRC also becomes the new #2…with $233 billion in assets, First Republic’s failure now surpasses Silicon Valley Bank’s closure as the second largest in U.S. history.
And the timing couldn’t be any better. The latest meeting of the Federal Reserve’s rate setting committee is set to conclude this Wednesday, with monetary policy a major contributor to the woes plaguing the bank sector.
The fastest rate hiking campaign in history is denting the value of bonds that banks hold as reserves, eroding their capital cushion. At the same time, deposits are fleeing as cash can earn a better return elsewhere. Those are driving forces behind the recent historic bank failures.
But developments around FRC isn’t expected to slow the Fed down, where another 0.25% rate hike is a lock as indicated by market implied probabilities that you can see in the chart below.
Now the question becomes if FRC is reigniting the bank crisis, and presents a systemic risk to the capital markets and economy. Here are several metrics I’m tracking to answer that question.
Can the Bank Crisis Stay Contained?
Despite a two-month period that witnessed two of the three largest bank failures in U.S. history, along with the hastily arranged takeover of Credit Suisse by UBS, financial markets have stayed remarkably calm.
There are several ways to measure and monitor stress in the financial system. After all, the cost and ability for businesses to access capital markets is how challenges facing banks make their way to main street. If banks are forced to retrench by restricting capital, that will slow the economy and ultimately impact corporate earnings.
That’s why I’m frequently checking measures of financial conditions to determine if the woes plaguing the bank sector are spilling over to the broader economy and capital markets.
The Fed publishes several indicators of financial conditions and capital market stress, like with the Chicago Fed’s National Financial Conditions Index. This gauge measures stress in various corners of the market, and conditions are still looser than the historical average despite the events in the bank sector since March. You can see that in the chart below, where the current reading is below zero which represents the average (below zero = looser conditions). Conversely, a move above zero would signal that the events in the bank sector could restrict economic activity.
I also rely heavily on high yield bond spreads for monitoring signs of stress. The spread represents how much extra compensation investors are demanding to lend to companies with lower quality financials. If the outlook for the economy deteriorates and odds increase for a default among the most vulnerable companies, the cost of high yield debt can jump quickly.
The chart below shows high yield spreads since the start of 2021. As spreads moved higher into 2022, they’ve since traded in a range. To signal that the bank crisis is spreading, I am watching for a range break to the upside over the 6% mark.
Another way to monitor high yield markets in real time is with junk bond exchange traded funds (ETFs), including JNK and HYG. Here’s the chart of JNK below, which has been carving out a triangle consolidation pattern since last August.
These tend to be continuation patterns, which means the chart resolves in the direction preceding the pattern. In this case, you would expect a downside resolution. But I keep an open mind with these patterns by simply waiting for a trendline to break in either direction. A breakdown would signal broadening concerns over the economy due to the bank crisis.
Those are key metrics I’m watching as the bank crisis escalates once again. High yield spreads and junk bond ETFs are especially a great way to monitor stress since these are real time and updated every day.
The drama around First Republic and the bank sector is also coinciding with the infamous “sell in May and go away” period. That’s a reference to the stock market’s six month stretch from May until November that is historically associated with a period of lackluster returns.
Here’s some stats from Ryan Detrick around the period. You can see in the table below that the May through October period has the lowest average return and is tied for the lowest win rate for the S&P 500 going back to 1950.
And with the ongoing uncertainty around the bank sector, there might be something to it this year. That will especially be the case if the financial market stress picks up and spreads beyond a few regional banks. The metrics I discussed above will tip off any spreading contagion from the bank crisis.
But there’s another reason I’m concerned over the intermediate-term outlook, and it has to do with the deteriorating breadth picture. Even as the S&P 500 and Nasdaq 100 are taking out key resistance levels on the upside, the majority of stocks are actually trading in downtrends. That’s evident over both short- and intermediate-term time frames.
Here’s an updated chart of the percent of stocks trading over their 20-day moving average along with the S&P 500 Index. While the S&P 500 is trading near the highs of 2023, only 44% of stocks are in short-term uptrends.
That backdrop means I’m still being cautious with new positions by sizing more conservatively, but I will still take breakouts that meet my criteria. And there’s one area in particular that might see a breakout if uncertainty drives a flight to safety, and that’s with gold.
The chart below shows the three-year history of the GLD gold ETF, which so far is holding key moving averages as price consolidates just below the highs that have been tested three times since 2020.
Many gold miners are testing key resistance levels as well. I have RGLD on my focus list if we start to see a breakout in miners, where I’m watching for a move over the $145 level with RGLD in the chart below.
That’s all for this week. The coming weeks are packed full of catalysts, including more earnings reports, another Fed rate-setting meeting, and ongoing drama around the debt ceiling. Throwing First Republic’s failure into that combustible mix and you should be prepared for volatility in either direction. But as is the case with any market environment, the key is to stay objective and disciplined in your trading plan.
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Disclaimer: these are not recommendations and just my thoughts and opinions…do your own due diligence! I may hold a position in the securities mentioned in this report.