The Color Of Money During Recession

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In a recent article that discussed the components of the S&P 500, the following observation was made:

ETFs based on Oil & Gas and Financials are beginning to register a subtle but noticeable increase in volumes.

While the value proposition and outlook for energy instruments was laid out in a subsequent article, financials have to be a little more nuanced.

“Money” Instruments: The Year So Far

The outlook for the banking industry in 2022 had largely been upbeat, given how sector performance is strongly correlated with events such as the reserve releases and improving loan growth, better investment manager performance, rising premiums and insurance as well as property price indexes in real estate in recent times.

The “Equity Trap” article summarized the outlook for gold (and gold miner ETFs by extension) thus:

Potentially, if efforts to contain inflation find little effect, there is some expectation among market watchers that the price of gold might begin to rise.

As inflation continues to increase on a year-on-year basis, this has certainly been true. Deutsche Bank broke ranks from its Wall Street counterparts to state what seasoned investors have been concerned about over the past several months: a recession is expected.

Crypto investments, while increasing in volume, hasn’t seen nearly the same immunity to “fiat” market events that some vocal proponents had been known to espouse in the past. For example, while Bitcoin ushered in the new year with a 62.3% increase in value on a year-on-year basis, it rapidly shed 19% over the course of January. While prices did improve over the next month, March began with the benchmark cryptocurrency down nearly 7% relative to the new year (with April seeing this drop reduced to 3%).

Any meaningful analysis should turn the lens into the past to put into perspective the outlook for what is turning out to be a year of disruptions. To analyze the world of “money” instruments, let’s consider two ETFs: the VanEck Vectors Gold Miners ETF (NYSEARCA:GDX) and the Financial Select Sector SPDR ETF (NYSEARCA:XLF).

Leading tickers in the banking industry will also be considered: HSBC Holdings plc (HSBC), Barclays PLC (BCS), Citigroup Inc. (C) and The Goldman Sachs Group, Inc. (GS).

Gold Futures levels as well as Bitcoin (BTC-USD) prices will subsequently be added into the mix.

ETF Comparison: Gold vs Financials

Just as with the ETF comparison in the “Clean Energy vs Fossil Fuels” article published recently, proximate ratios are calculated in the constituent average as well as weighted average (driven by ETF constituent weight) formats over a series of one-year windows – with two additional windows to show the most recent states – in order to evaluate the two ETFs.

PE, PS and PB Ratio for XLF and GDX

Source: Created by Sandeep G. Rao using data from Bloomberg

One immediate item of interest that pops out in this picture is the extremely high average Price to Sales (PS) Ratio in GDX as observed in the start of the year. This is attributable to Australian company Capricorn Metals Ltd (OTCPK:CRNLF) – which had a PS Ratio of over 11,210 and a Price to Book (PB) Ratio of over 8.9 – which is well over the average. The weighted average method paring the ETF’s PS Ratio metric down to (a high but comparatively reasonable) value of 40.57 validates the method’s robustness in rationalizing analysis.

On the basis of weighted-average trends, the following observations can be made:

  • As a whole, XLF has relatively more “rational” metrics than GDX.
  • GDX shows enormously overvalued PE Ratios in mid-2019 which had pared down to 3-year lows of around 20 before ratcheting up to nearly 29 in the present. In contrast, XLF’s PE Ratio – after a modest high in mid-2021 – continues to pare down in the present.
  • GDX’s PS Ratio – after discounting the aforementioned bump due to Capricorn – has been in a “steady state” for at least 3 years. This is the case with XLF as well.

The key takeaways here are that the constituents of both ETFs – for the most part – are stable and rationally considered companies. However, in general, gold miners’ forward-facing outlook over their prospects lends a slightly greater edge in its valuation.

The continuing “ratio cool-off” in XLF is an interesting phenomenon. In times of recessionary build-up, banks and financial services have varying edges and challenges relative to other sectors. For an analysis of the banking sector, let’s consider some institutions of renown: HSBC Holdings plc and Barclays PLC form a Europe/Asia axis while JPMorgan Chase & Co (JPM), Citigroup Inc and The Goldman Sachs Group Inc form a more U.S.-centric axis.

Global Banks: Hidden Minutiae

Using the same set of windows as in the ETF analysis, let’s consider these leading banks’ ratio performance in recent years. The results are quite interesting:

PE, PS and PB Ratios for Global Banks

Source: Created by Sandeep G. Rao using data from Bloomberg

The core summary of trends from mid-2019 to the present are:

  • All the banks have seen a drop-off in PE Ratios, with Barclays being the worse for wear.
  • Only Goldman Sachs has a net increase in PS Ratio, with Citigroup showing the biggest drop.
  • JPMorgan and Goldman Sachs show a net increase in PB Ratio, with Barclays showing the biggest drop.

In terms of short interest as recorded in U.S.-based instruments (i.e. the ADRs of Barclays and HSBC in this case), the Europe/Asia axis has had a substantial increase in short interest, along with Citigroup. However, it is evident that short interest in both JPMorgan and Goldman Sachs (despite their comparative better ratios) have also registered an uptick in the year till date.

Note: Bloomberg calculates short interest in approximate 15-day intervals. The numbers quoted are from the nearest available date in the past. The ending numbers are as of March 31st this year.

Current events’ impact on revenue-generating activities aren’t immediately clear for the banks’ “market-related” divisions. For instance, while SPACs face increasing regulatory pressure – with the current year not being deemed conducive for IPOs either – virtually every major U.S. bank (and likely other global banks) anticipates an increase in trading revenue.

Debt servicing forms a crucial part of major banks’ revenue streams. This data is generally not available on a daily basis. However, as of end of 2021, there have been some very interesting trends.

Loans and Asset Ratios: Global Banks

Source: Created by Sandeep G. Rao using data from Bloomberg

Some key points from the banks’ lending-derived metrics relative to Q3 2019 are:

  • Only Goldman Sachs has registered a net increase in the “Loans/Deposits” metric, with JPMorgan being down nearly a third.
  • Fortunes in the dreaded “Non-Performing Loans/Assets” metric are mixed: HSBC, Goldman Sachs and JPMorgan have seen an increase (in descending order) while the rest have seen a decrease.
  • However, Goldman Sachs had registered an increase in “Loans/Assets” while all others had registered a decrease – with JPMorgan and Citigroup the worst-affected in nearly-identical performance.

The general drop in lending activity and rising non-performing loans in the mix are symptoms of a larger issue: it is likely that rising inflation is eating into savings and margins to the point of affecting the ability of many businesses as well as wage-earners in servicing their debts. The U.S. job market is also witnessing a steady increase in the number of retirees returning to the workforce.

Price Trends and Broad Recommendations

Across the windows described, the trends in instrument performance have been very mixed but not without some distinctive characteristics.

Stock Price Trends in GDX, XLF, Banks, Gold and Crypto

Source: Created by Sandeep G. Rao using data from Yahoo! Finance

Broadly:

  1. Both gold miners and gold futures have seen a substantial increase in the year till date (YTD). However, the gold miners do show a little more volatility relative to gold prices. This is likely a function of their relative overvaluation; overvaluation lead to a more pronounced reactionary nature when it comes to market events.
  2. Bitcoin’s recent performance puts paid to the idea that it could be an effective replacement for the “storehouse of value” status that a classical element like gold has (at least for the near future). In fact, cryptocurrencies have generally shown a strong correlation with “fiat” market events during the downturn seen over the past several months.
  3. While virtually every bank has shown a downturn in the YTD, HSBC is an outlier in that it hasn’t. Given the bank’s commitment towards expanding is service offering even further in the East over the past year or so, this is likely to be an additional point in favor of the argument made in an earlier article that the East and West are steadily moving towards decoupling. Note: “The East” isn’t just the People’s Republic of China.

Trends in Assets Under Management (AUM) for the two ETFs paint an interesting picture as well.

Assets Under Management: GDX vs XLF

Source: Created by Sandeep G. Rao using data from Bloomberg

Around the end of 2020, XLF had witnessed an explosion in AUM that had substantially outpaced the trends seen in GDX. In the YTD, XLF had witnessed a net fall of 5% in price and a net decrease of 11% in AUM. Meanwhile, GDX had seen a net rise of 27% and a net increase in AUM of 23%. Thus, while there have been divestitures from both these instruments, it is much more pronounced in XLF than in GDX.

In the Tesla stock price modelling article, the following observation was made:

… the PS Ratio has the highest correlation with the stock price trajectory in more recent times.

This is a broad trend seen in most stocks recently. In terms of PS Ratios, the highest ratios seen in XLF’s constituents haven’t been banks for quite some time now.

Leading Price to Sales Constituents in XLF

Source: Created by Sandeep G. Rao using data from Bloomberg

MSCI Inc (MSCI), CME Group Inc (CME) and MarketAxess Holdings Inc (MKTX) are intricately intertwined with financial markets. Meanwhile, Moody’s Corporation (MCO) – owned by Berkshire Hathaway (BRK.B; BRK.A), itself a leading constituent by weight – and S&P Global Inc (SPGI) earn fees via ratings made to market instruments.

As highlighted in the “Equity Trap” article, there is no alternative to being invested in the market.

In light of the facts presented, the broad recommendations are thus:

  1. Present economic circumstances highlight the value of gold over alternatives such as cryptocurrencies. Investors – both “fiat” and crypto – should consider adding gold assets (either outright or through the likes of GDX) into their “core” portfolio for overall performance stabilization (“core” and “satellite” portfolios were discussed in an earlier article).
  2. The presence of “market-involved” companies (as those listed above) in XLF is a welcome source of diversification which might prove to be valuable in the months to come. However, PE ratios are extremely high in the aforementioned companies and their constituents weights are low. Current circumstances essentially represent a fork in the road: investors holding a preponderance of banking stocks and/or the likes of XLF would do well to consider diversification but not necessarily an outright divestiture.

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