What's up with the Banks?

The market has recovered nicely since the late February sell-off. It took awhile but the financial stocks have finally awakened and joined the party. Or have they?

Let's take a look at two ETFs. First we have XLF, the SPDR Financials ETF, and then KBE, the streetTracks KBW Bank Index ETF.



What's going on with this chart? Why the divergence? The chart above shows over a 4% difference in performance between XLF and KBE.

We have a few themes playing out here: mergers and acquisitions, interest rates and the problems with sub-prime mortgages.

In the case of XLF, we have an ETF that is riding high based largely on the biggest investment bank/broker/dealer stocks. These stocks have been benefiting from the fact that the world is awash in liquidity and interest rates are at a manageable level. It is a perfect environment for leveraged buyouts and every day we hear about a new multi-billion dollar deal. The fees generated by these deals go straight to bottom line of the investment banks. By market value, these stocks are the largest ones in XLF and their investment banking profits are overwhelming any problems they are having in other areas. As an example, Merrill Lynch just reported earnings. They bought a mortgage lender, First Franklin, at the top of the market. Were Merrill's earnings negatively impacted by having this albatross around its neck? Not at all. Merrill was busy doing deals and racking up profits in its investment bank while packaging up all those mortgages into securities to be sold to someone else.

KBE, on the other hand, is comprised almost exclusively of banks. You'll see Citigroup and JP Morgan Chase in their top-10 holdings but you won't see Merrill. Banks are not exactly enjoying a day in the sun. Interest rates are not especially high at the moment but they are not as low as they once were. As a result, we have seen a reduction in the margins banks earn on lending. We have not seen the sub-prime mortgage problems spill over into the general economy but there is no doubt it is affecting the regional banks. Loan loss reserves are being increased across the board; large banks and small banks have all started taking charges for increasing reserves and this has been affecting earnings reports. Credit policy is tightening. Washington Mutual, also one of KBE's top-10 holdings, has taken a hit recently for all the above reasons.

So what we are seeing is that there is a stratification in the financials. There is a segment of large broker/dealer/investment banks that are grabbing the headlines but, for the most part, the world of financial stocks is largely composed of regional banks and other lenders involved in commercial lending, mortgages, auto lending, etc. The financial sector comprises one of the largest sectors in the major market indexes. Will we see a sustained rally when there are signs the majority of financial institutions are lagging?