U.S. Bank Stocks: Don’t Fade The Tail Risk

US bank stocks (KRE) have underperformed the S&P 500 by ~28% the last 12 months.

US Bank Stocks

source: Yahoo Finance

The market is pricing-in elevated solvency risks within the banking sector’s loan books. Bank management teams generally agree with the market’s risk assessment – the banks have nearly doubled their loan-loss provisions over the past 6 months.

Loan-loss provision

source: FRED

Bank management teams are prepared for a material increase in charge-offs (loan defaults). Economic fundamentals are improving from their nadir earlier this year, but still imply massive credit distress at current levels. The following charts show 1. Consumer credit delinquency rates vs. unemployment, and 2. Commercial/Industrial delinquency rates vs. Industrial Production.

consumer loans

Commercial Loans

source: FRED

Credit fundamentals have diverged from economic fundamentals because of massive increases in government spending in 2q and 3q (by far the largest spending surge going back to 1960!). Loan programs like the PPP kept businesses afloat, and federal additions to unemployment benefits actually increased wages.

saupload fredgraph 3

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source: FRED

Historic government stimulus has buoyed commercial and individual credit. Congress is attempting to pass another (but smaller) stimulus bill ASAP. Widespread vaccine distribution is set to occur in April/May. Will economic life “return to normal” this summer without the Covid economic disruption resulting in any real credit distress? What are the potential scenarios and what do they mean for KRE (assuming widespread vaccine distribution in May)?

  1. Congresses passes the proposed stimulus package, and then passes another meaningful stimulus package once Joe Biden takes office. If Dems can win both senate seats in Georgia and thus control the senate, the chances of this scenario playing out increase.
    • KRE outperforms the S&P 500 as the government effectively says they won’t allow for credit distress in the financial system.
  2. Congresses passes the proposed stimulus package, and then struggles to pass another meaningful stimulus package in February. Political gridlock ensues as Republicans hold the senate.
    • KRE marginally outperforms the S&P 500 due mostly to reversionary powers (i.e. the underperformance was more cyclical than structural) rather than bullish fundamentals. But absolute performance may be weak (or negative) as the market looks past government expenditures toward the day of Covid economic destruction reckoning.
    • Even with the vaccine on the horizon the market will continue to price in elevated credit risk. For example can airlines and commercial real estate remain viable businesses when capacity is underutilized indefinitely (which it will be even post-vaccine)?
  3. Congress is not able to pass a stimulus package and effectively signals to the market that the artificial economy (at least the piece propagated by the fiscal side) is over and the capitalist system that we claim to have rears its head.
    • KRE begins to look more like energy stocks (until recently), and only goes down. The market hates both uncertainty and undistorted, cold, stark economic reality. The market begins to price in questions, some short-term some more structural, such as:
      • Will unemployment shoot back up to 10+%?
      • Will Industrial Production stay meaningfully negative for several quarters?
      • Will the massive wave of corporate bankruptcies that never materialized finally come home to roost?
      • Can airlines, trains, commercial office space, bars, restaurants, brick and mortar retail, etc. remain viable businesses while massively underutilized?
      • Maybe there isn’t a free lunch?


  • The market believes congress will pass at least one more stimulus bill, and it assumes a decent chance that further bills will pass. The market believes these fiscal actions can shield the economy from the Covid driven economic devastation that has occurred.
  • While the base case suggests KRE trades higher (at least relative to the S&P 500), the potential bear scenario could be MASSIVE such that the risk/reward isn’t attractive (not a tail risk I’m willing to fade). Furthermore I’m not bullish the S&P 500, so that makes owning KRE unhedged difficult as well.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Credit: SeekingAlpha

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