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If bank stocks seem ill, how long can the Dow resist infection?

Regulations, yield curve pressure banks: Pro

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Regulations, yield curve pressure banks: Pro

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Big bank stocks have been sickly in recent months, often a symptom of a less-than-healthy market – one in need of a prolonged rest at minimum, or a more intense selloff that would allow the fever to break.

The action in bank stocks is a long-trusted vital sign used to gauge the broad condition of the stock market. Yet in the chop-around nervous trading range of recent months, they haven’t received much attention.

The KBW Bank Index (^BKX) is off about 8% from its early-April high, and the performance of its most widely tracked members has been worse still. Bank of America Corp. (BAC) has lost 19.5% since a January high, while Citigroup Inc. (C) is down more than 15%. JP Morgan Chase Co. (JPM) and Goldman Sachs Group (GS) are both off around 13%. The only stalwart action is in Wells Fargo & Co. (WFC), hovering just below its all-time high near $50.

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Struggling Financials

The sharp correction in the Russell 2000 small-cap index, the downside gut check in hyper-growth tech names and the jarring compression in Treasury yields have all been obsessed over as signs of risk aversion and rising doubts about the broadly predicted global economic acceleration.

The pronounced weakness in the banks is of a piece with these worries. Banks sit at the nexus of economic growth expectations, housing activity, loan demand, credit conditions, financial stability and investor risk appetites – thus, their bellwether status.

A 'market cautious' time

Agreeing that there “hasn’t been much discussion of weakening bank charts,” Chris Verrone, technical market analyst at Strategas Group, says, “I do think the flatter curve has something to do with it. But nonetheless, it is one more item that keeps me ‘market cautious’ as we push into the weaker seasonal period.”

The “flatter curve” refers to the narrowing of the gap between short- and long-term Treasury yields, resulting from the surprising rally in Treasuries that has pulled 10-year yields down to 2.5% from 3% early this year. While there are various plausible, and not all troubling, reasons for the sag in yields, the flatter curve directly saps bank profits and often signals a tempering of growth expectations.

The setback in bank shares also fits with a dominant theme in which the “easy trades” – positions that were popular and led the market nicely higher in 2013  got too crowded and have undergone a painful payback period. Small-caps, social media and biotech were in that category, as were banks, to a lesser degree.

The latest Merrill Lynch global fund manager survey shows professional investors dumped bank stocks aggressively in the past several weeks, dropping their allocation to the sector to a 10-month low. But because bank shares were enjoying extreme popularity entering 2014, funds’ exposure to the group remained far above the historical average. The economic pickup, healing housing market, easy central-bank policy and anticipated rush of higher dividends and stock buybacks from mega-banks were all commonly held reasons to love the bank stocks coming into the year.

One reason some commentators are trying to “explain away” the underperformance of banks as a warning sign for the broad tape is the role restrictive regulatory decisions has had on the likes of BofA and Citi. These banks have shouldered yet more big fines for lending abuses in the housing bubble-and-bust years, and have been denied permission to share more capital with investors through higher dividends and buybacks. The idea is that they’re suffering from a squeeze from D.C., so maybe their poor stock performance is not the cautionary market signal it has been through history.

But is there a comforting way to shrug off the laggard action in Goldman, despite firm credit markets and a resurgence in corporate-merger activity, which should benefit the firm?

It’s quite possible that when (if?) Treasury yields bounce and the curve widens out a bit, bank stocks will get a reprieve and deliver a “catch-up” move with the headline Standard & Poor’s 500 Index, which of late has been supported by safe-haven sectors such as utilities, consumer staples and energy shares.

And, sure, it could be that these market segments are undergoing surgical, sector-specific corrections of excessive valuation and investor enthusiasm, sparing the broad list from deeper damage.

Yet combined with the slippage in consumer-cyclical, small-cap, “lower quality” and other stocks geared to liquidity and risk-seeking, the conspicuous weakness in the banks offers one more reason the burden of proof remains on the bulls for the moment.

History would suggest that, unless or until the banks decisively begin to recover, the choppy, low-momentum digestion period we’ve been in will continue.

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