It's been a dreadful 2020 for bank stocks as the combination of low interest rates and investors' preference for growth fare are punishing this cyclical value group.
What Hapened: Those factors are making for a toxic brew for the Direxion Daily Financial Bull 3X Shares (NYSE:FAS), which is lower by nearly 59% year-to-date. FAS is designed to deliver triple the daily returns of the Russell 1000 Financial Services Index.
Compounding the woes of bank equities and FAS is that in the first half of the year, due to the coronavirus economic shutdown, banks set aside a staggering $72 billion in capital to cover sour loans. Then the Federal Reserve said no to dividend hikes and buybacks.
Why It's Important: To be sure, the U.S. economy isn't close to being all the way from the impact of COVID-19. Unemployment is still running high and there's evidence suggesting that many job losses that were once believed to be temporary are becoming permanent.
However, that's not the end of the case for FAS. If the economy perks up more rapidly than expected, there's a credible chance banks will be able to tell investors they set aside too much capital for bad loans in the first half of 2020 and that those reserves can be translated back into earnings.
“Yet, banks might be reserving more than the losses they eventually will incur. On second-quarter earnings calls, many bank executives hinted that their reserve builds were likely to peak in the second quarter,” reports Barron's. “JPMorgan Chase (NYSE:JPM) executives noted that the bank leaned a bit more on downside scenarios when building its reserves. Even if the banks’ dour economic projections come true, the accounting treatment of those reserves might permit them to be released into earnings once the economy improves and losses are covered.”
JPMorgan Chase is the third-largest component in the index FAS tracks. Citigroup (NYSE:C), the eighth-largest member of the FAS index, set aside $10.5 billion for loans gone bad in the first six months of the year.
What's Next: Beyond loan loss reserves being turned back into earnings, a catalyst for FAS and it's one that's a long-time coming, would be an earnest rebound by value stocks.
Value stocks currently trade at some of the deepest discounts relative to growth seen in history and value often performs well following economic contraction. If history repeats, the stage could be set for upside for FAS. Finally.