The Importance of Banks to Stock Market Returns
By Adam Thurgood on September 25, 2023
With about a week to go until we wrap up the third quarter of 2023, there are still plenty of odd things happening in markets. The gap between the S&P 500 and the equally-weighted index of the same securities continues to be awfully high, sitting at over 10% at the time of this writing. While that differential is a little nutty, the differential between the S&P 500 and the bank index is certifiably crazy! Take a look at the chart below, which shows the massive 35% differential between the two indices.
The banks have been annihilated this year, as the yield curve remains deeply inverted and the rise in interest rates has wreaked havoc on their asset base. From a theoretical perspective, banks are critically important to our economy. They perform essential functions that keep economic activity moving forward. As such, it would seem that an unhealthy banking system would spell trouble for equity markets. Yet we aren’t seeing that play out, at least not in the overall index, which has left me scratching my head.
I decided to dig a little deeper into the data to test if my assumption that overall stock indices would struggle if the banking sector was performing poorly. I looked at the performance of broad stock indices in the U.S., Japan, the Eurozone, and emerging markets under two regimes; when banks are trending up and when they are not (defined as being above or below the 18-month moving average). The results were quite interesting!
In Japan, the overall market struggles when the banks are below their 18-month moving average.
In the Eurozone, the relationship also holds.
The same can be said for emerging markets.
Yet in the United States, the relationship is much weaker.
Breaking the data into a risk/return scatterplot presents the story in much clearer terms.
When the banking sector is performing well, stocks performed well, regardless of the region. Overall volatility for each region was below average during the positive bank regime. On the flip side, volatility levels were significantly higher when the bank index was below its 18-month moving average. Additionally, absolute performance at the overall index level was very weak in emerging markets, the eurozone, and especially Japan. Yet, the U.S. market actually performed better in absolute terms during periods of bank weakness.
I wish I had answers for why this is the case. I am still thinking through various reasons for this phenomenon and reaching out to other strategists to get their take. If I arrive at a thesis at some point in the future, I’ll be sure to write a follow-up piece. That being said, there are lessons we can learn from this data:
- Volatility is elevated during bank weakness, which can help inform risk management decisions
- The time to be bullish international markets is when their banks are performing well
As we stand today, both the Japanese and European banking indices are in the green, suggesting an attractive environment for equities in those regions.
