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Submitted:

Summary: Financials Will Continue To Underperform

Nobody really knows what is on banks’ books.

Low interest rates represent a huge headwind for banks.

Financial sector continues to underperform the broader market.

Currency gyrations add to uncertainty.

Market Neutral trade idea.

There is an old joke on Wall Street:

One guy tells another guy: can I borrow $100?

The other guy says: No problem, but all I have with me is $80

The first guy responds: It’s OK, I will take $80 and you will owe me $20.

This joke comes to mind every time I attempt to analyze big banks’ books and earnings. It is virtually impossible to determine who owes who, what, where and why. The most common financial ratios do not really apply to the big banks due to their complex off shore and international dealings, trading activities, and most importantly, lack of trust and transparency. Instead of dissecting individual bank’s financial fillings, let’s take a look at the macroeconomic picture and what it may mean for investors.

So far, 2016 has been a difficult year for the financial sector (NYSEARCA:XLF) . Banks entered this year expecting several rounds of interest rate hikes, as was telegraphed by The Federal Reserve. But things haven’t turned out in their favor. Even after a strong Unemployment Report last Friday, Fed Funds Futures assign only 23% chance of one (1) rate hike by December of 2016. On top of that, the longer-term Treasury bonds and notes continue their relentless rally, fueled by investors’ search for yield, which is sending interest rates to record lows. The US 10-year Treasury Yield is sitting at 1.39%. The Market is telling us that low interest rates are here to stay. This trend keeps applying more and more pressure on the banks, by squeezing their margins.

Earlier this year, it was the falling oil prices, which hurt banks’ earnings in the first quarter. Big banks have large oil and gas loan portfolios, and with the decline in oil prices, collateral on these loans are losing value. Then there are persistently low interest rates. And now the Brexit vote, which sent multiple major currencies into a tail spin. A stronger dollar has also hurt bank profits with global operations. Nobody knows if the banks are hedged against major currency moves. All of the above is a perpetually tough macro environment, which shows no signs of improving. Even if banks’ trading operations offset some of the outlined head winds (that is a big “IF”), I sincerely doubt, it will reignite investors’ enthusiasm towards shares of major banks or the sector ETFs like XLF.

All this uncertainty and negative macroeconomic environment has resulted in continuous underperformance of the financial sector versus the broader market. The following represents several examples of performance for 2016:

JPMorgan Chase (NYSE: JPM-4.30%

Wells Fargo (NYSE: WFC-10.73%

Citigroup (NYSE: C-18.69%

Bank of America (NYSE: BAC-21.18%

Goldman Sachs (NYSE: GS-15.86%

XLF (financial select sector SPDR ETF) -2.78%

Vs:

SPY (S&P 500 SPDR ETF) +5.9%

The following chart illustrates the ratio of the S&P 500 (as represented by SPY) vs. the financial sector (as represented by XLF). SPY divided by XLF. The rising line means XLF is underperforming. It is evident that the Banks have continued to underperform the broader market over the last three years, and in fact, this trend has been accelerating over the last few months.

SPY divided by XLF

If you agree with my assessment that the Banks will remain to be in trouble in the months ahead, there are several ways you can approach this information.

1. Just stay away from them. Look for opportunities elsewhere.

2. Sell short XLF. Not a bad idea, but it requires discipline as well as understanding that it will fit your portfolio. Also, if the market stays strong, it can take everything up with it (rising tide lifts all boats).

3. Buy Put Options. For example, December 23 Puts can be bought for 1.27. That is $127 per contract. Your breakeven point will be 21.73 (23 – 1.27). That is rather inexpensive. Obviously, when it comes to being long options, you have to be ready to lose that entire premium if XLF rallies or doesn’t decline at all.

4. Another option is a market neutral trade or a pair trade. This is a typical hedge fund type trade where you bet that XLF will underperform the broad market, for example SPY. This can be accomplished by buying (going long) SPY and selling short XLF. This has to be done in a dollar neutral manner in order to stay true to the percentages. SPY is trading at 212.65 per share, while XLF is trading at 22.92. The ratio is 9.28 (212.65 divided by 22.92). Creating a market neutral trade will require selling short 9.28 shares of XLF for every 1 share of SPY bought long. You can simplify it to 9 to 1 or 10 to 1. If you take a look at the above chart, the idea is that XLF will continue to underperform SPY regardless of the overall direction. In a market neutral trade, the objective is not to see your long going up and your short going down (that would certainly be ideal). In most cases, one will be a winner and the other will be a loser. You are just trying to capture the difference of the rate of return. You enter it at the same time and you exit it at the same time. You treat it as one trade. For example, if SPY goes up 10% and XLF goes up 6%, you pocket the difference (4%). Same applies to the downside: if SPY falls 10% and XLF falls 15%, you pocket the difference (5%). Essentially, if you look at the above chart one more time, you are betting that the ratio will continue to rise. Practically you just created a new tradable security, which is called SPY divided by XLF.