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May 29, 2008

Pictures du Jour: Banks to Indicate Direction for Stock Market
by Prieur du Plessis

Global stock markets topped out on the back of the sub-prime/credit debacle in October 2007. Prices subsequently moved lower until reaching climatic bottoms in January/March this year, triggering rallies throughout the world until a few days ago. The big question investors are grappling with at this stage is whether the rise in prices has simply been a bear market rally, or whether we are back in a primary bull market.

I have previously said: "Whereas I am doubtful about the longevity of the rally, I am also not in the Armageddon school. Is the answer perhaps a 'muddle-through' market, characterized by below-average returns? That is my hunch, for what it's worth." (See post entitled "Poll of the Week: Stock Markets - Which Way Jose?" of 25 April 2008.)

In searching for answers, it is appropriate trying to get a grip on the direction of banking stocks as these are usually a good indicator of the market as a whole, especially given the large proportion of financial services of many major stock markets.

The following is a long-term chart of the S&P Banking Index relative to the S&P 500 Index, showing clearly the massive underperformance of banking stocks since the middle of 2002:

Sources: Bloomberg; I-Net; Plexus Asset Management.

I have pulled out a few fundamental graphs pertaining to the US situation in order to assist in gauging the lie of the land.

Firstly, as far as lending standards are concerned, US banks are still in tightening mode.

Sources: Federal Reserve Board; I-Net; Plexus Asset Management.

But it would appear that the lending standards could start easing during the current or next quarter, at least when considering the historical relationship with the Fed funds rate.

Sources: Federal Reserve Board; I-Net; Plexus Asset Management.

Interestingly, banking stocks have historically started outperforming the S&P 500 Index around two to three quarters before lending standards ease.

Sources: Federal Reserve Board; Bloomberg; I-Net; Plexus Asset Management.

The relative performance of banking stocks is largely driven by the "mortgage margin". The latter has been defined for this purpose as the difference between the 30-year mortgage yield and the 30-year government bond yield, serving as a measure of risk in the housing market. The most recent numbers (not shown on the graph) indicate a significant swing in the mortgage margin as the long bond yield rose while the contract rate on 30-year, fixed-rate conventional home mortgages fell.

Sources: Federal Reserve Board; Bloomberg; I-Net; Plexus Asset Management.

Taking the analysis one step further, the mortgage margin in turn leads the lending standards by about two quarters.

Sources: Federal Reserve Board; I-Net; Plexus Asset Management.

The next graph shows the relationship between the mortgage margin and the Fed funds rate.

Sources: Federal Reserve Board; I-Net; Plexus Asset Management.

Putting all this together, it would appear that the underperformance of US banking stocks relative to the S&P 500 Index could be on its last legs. This conclusion is based on the mortgage margin appearing to be peaking, the Fed funds rate leading the lending standards by approximately three quarters, as well as the relationship between the mortgage margin and the Fed funds rate.

Caveat emptor: This is a relative analysis and does not provide a tool for short-term timing decisions. It does, however, alert one to the factors at play regarding the performance of banking stocks - factors beginning to point to the possible initial stages of the long-term bottoming out in the relative performance of banking stocks and, ultimately, to better prospects for stock markets as a whole.

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Dr Prieur du Plessis
investmentpostcards.com

With 25 years' experience in investment research and portfolio management, Dr Prieur du Plessis is one of the most experienced and well-known investment professionals in South Africa. More than 1 000 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns. He also published a book, Financial Basics: Investment, in 2002.

He holds the following degrees: BSc (Quantity Surveying) (Cape Town), HonsB (B & A) (cum laude) (Stellenbosch), MBA (cum laude) (Stellenbosch); and DBA (Doctor of Financial Management) (Stellenbosch).

Prieur is chairman of the Plexus group of companies, which he founded in 1995. Previously he was general manager: portfolio management at Sanlam, responsible for the management of investment portfolios with total assets in excess of $5 billion.

Plexus is a pioneer in the mutual fund industry and has achieved a number of firsts under Prieur's leadership. These include the authoritative Plexus Survey, a quarterly analysis of the consistency of the performance of unit trust management companies, the Plexus Offshore Survey, the Plexus Unit Trust Indices, and the PlexCrown Fund Ratings.

Plexus is the South African partner of John Mauldin, American author of the most widely distributed investment newsletter in the world, and also has an exclusive licensing agreement with California-based Research Affiliates for managing and distributing its enhanced Fundamental Index™ methodology in the Pan-African area.

In 2001 Prieur received the Santam/AHI Business Leader of the Year award for corporate leadership, business acumen and entrepreneurial flair. He was also profiled in the book South Africa's Leading Managers (2006). Plexus received the AHI/Old Mutual Enterprise of the Year award in 1997 and was also included in the book South Africa's Most Promising Companies (2005).

Prieur is 52 years old and lives with his wife, TV producer and presenter Isabel Verwey, and two children in Welgemoed, Cape Town. His recreational activities include long-distance running, motor cycling and reading. He belongs to the Cape Town Club, Johannesburg Country Club, Gordon's Bay Yacht Club and Swiss Social & Sports Club.

Copyright © 2008 Dr Prieur du Plessis

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