FAS - FAS: The Worst Of The Banking Turmoil Seems Over For Now

2023-04-19 03:06:43 ET

Summary

• Direxion Daily Financial Bull 3X Shares ETF is down more than 30% since its March 3 high of $83 as a result of the banking turmoil.
• With hindsight and after the big bank earnings, it can be reasonably affirmed that most of the downside was caused by market overreaction.
• Thus, there is room for an upside, as the worst of the banking turmoil seems over.
• However, do bear in mind that highly leveraged ETFs remain risky as it magnifies the gains one can obtain from the normal price action, in both directions.
• Also, tighter credit conditions have increased the probability of a recession later this year, which in turn fosters market conditions where it is better to have a short-term outlook.

Learning from the banking earnings season, the aim of this thesis is to elaborate on a strategy to profit from a short-term market move made possible by the Direxion Daily Financial Bull ETF ( FAS ). This fund has lost more than 30% of its value since March and was trading at $63.49 a share at the time of writing, as shown in the chart below.

To make my point, I will also use the earnings data of Citi Bank ( C ), JPMorgan ( JPM ), and Wells Fargo ( WFC ) as well as go through some of the events that occurred during last month's banking turmoil.

First, I bring more precision to FAS as well as the index it tracks.

Understanding the Index which Drives FAS

This Direxion ETF tracks the Financial Select Sector Index or IXMTR at an accelerated pace of three times (3x). Now, IXMTR includes Berkshire Hathaway-Class B ( BRK.B ) as its top holding, which forms a sizable 14.85% of the overall weight as pictured below.

In addition to insurance, Berkshire which is down by 6.6% over the year, is involved in many other business activities including transportation, energy, and mining. Moving down the list, there are banks, diversified finance, and especially, mortgage real estate, on which a lot has been written in view of the risks they pose to the economy, and I will address them later.

For now, looking at IXMTR 's top holdings these are constituted mostly by the big banks, like JPM, Goldman Sachs ( GS ), and Bank of America ( BAC ). It certainly provides exposure to smaller ones like U.S. Bancorp ( USB ) and Zions Bancorp ( ZION ), but their weights are individually confined to only 0.75% or less.

Now, smaller banks that form part of the Invesco KBW Bank ETF ( KBWB ) saw their shares plunge, with the ETF suffering from a value erosion of more than 25% as shown in the orange chart below. By comparison, the Financial Select Sector SPDR Fund ( XLF ) proved less volatile. This fund which also tracks the Financial Select Sector Index provides exposure to larger banks in the same way as IXMTR.

However, bank runs that impacted First Republic ( FRC ), Signature ( SBNY ), and SVB Financial Group ( SIVBQ ) whereby depositors withdrew savings en masse have to some extent also been contagious to the shares of the big banks. This stems from the fact that they also hold long-dated U.S. treasuries as part of their overall assets and these have been devalued as a result of yields moving higher after the Fed aggressively raised interest rates since 2022.

Now, the Fed tightening monetary policy is normally favorable to banks as they benefit from more net interest income or NII since they can charge higher for money that they lend to borrowers out of the cheaper cash obtained from savers. But, during the banking turmoil, the negative effect constituted by treasuries on fixed-income portfolios was highlighted as well as liquidity issues which resulted in smaller banks having to sell government bonds at a loss. In the ensuing period of volatility, XLF and FAS lost over 10% and 30% respectively within two weeks, constituting a rude awakening to the reality of interest rate risk.

However, the financial results of the big banks show that the market may have overacted with investors focused too much on the fear factor that bank runs may spill over to the wider industry.

Bank Earnings Up to Now

First, Citibank's NII rose by 23% to $13.3 billion thanks to the U.S. central bank's most aggressive rate-hiking campaign in many years. As for deposits, these were roughly the same at $1.33 trillion from a year ago. This means that the much-feared outflows into money market funds, mostly due to fears of bank runs contaminating larger peers did not materialize.

On the contrary, JPM seems to have benefited from depositors exiting regional lenders and instead poured more money into the bank as it saw many new accounts being opened with an estimated $50 billion of deposit inflows being retained at quarter-end. As a matter of fact, deposits staged a recovery at the U.S largest bank (by assets) as they increased by 2% in Q1 compared to the previous quarter, while still being down by 7% on a year-on-year basis. Looking further, the megabank's NII rose by 49% to $20.8 billion, again showing the windfall gains provided by the Fed tightening.

Looking at the bottomline, bank earnings have been strong up to now and valuations (GAAP P/E) are 8 to 10 times compared to the historical 12 to 14 times. Now, for banks, more than other cyclical stocks, it is not just about profitability but also about the broader economy, and, here, profits have not been impacted by unexpected losses in commercial lending including from mortgage real estate.

Thus, with the most exposure to office REITs as of the end of 2022, Wells Fargo, whose deposits fell by 2% YoY in Q1, put aside a higher amount of $1.2 billion (including $643 million for commercial real estate) to deal with such losses. Nonetheless, this amount pales when considering that its net income surged by more than 30% to $5 billion, with NII being a major contributory factor as it surged by 45%.

Therefore, higher interest rates-driven profits do have the capacity to offset potential loan-related losses provided that banks do not lose more deposits to money market funds as investors chase higher yields. In this case, given the stress level banks went through, the single-digit outflows seen in deposits for the larger banks are encouraging. Pursuing on a positive note, the probability of a 25 bp hike at the next FOMC meeting in May exceeds 85% and favors banks' NIIs.

Conversely, inflated interest rates also pose risks to the wider economy as high borrowing costs reduce businesses' risk-taking appetite, but unlike 2008, this time around there is no credit issue exacerbated by non-transparent debt instruments. Also, the authorities have provided ample evidence that they are ready to provide backstops to prevent any spillover into the wider industry. To this end, banks have reduced borrowings from Fed lending facilities for a fourth straight week, implying that smaller banks are not being forced to sell securities at a loss and bearing more unrealized losses on their books.

Therefore, it looks like we are past the banking turmoil.

Using FAS after Being Aware of Risks

However, this outlook could be soured by a shallow recession occurring later this year, but I remind investors that as a highly (3X) leveraged ETF, FAS is about profiting from market moves over the short term. As an illustration, the one-month price performance below shows a 7.36% rise in XLF being translated into a 23.21% gain for FAS.

This shows that leveraged ETFs are indeed powerful tools built to magnify normal price actions, but with higher rewards come risks too.

As such, Direxion stresses that FAS seeks daily goals out of its underlying index, and one should not expect gains to follow over periods longer than one day. This is explained by the compounding effect whereby the higher the degree of volatility witnessed by the index over the trading period, the lesser the gains. This is again illustrated in the chart below when a 1.56% rise in XLF has not delivered a three times gain of 6.24% (1.56 x 3) gain in FAS as per the prospectus , but, only 4.15%.

This still represents a gain though, but, things can turn out worst, and there can be losses as well, especially given that FAS magnifies market moves in either direction. This brings me to the second point of caution as listed in the guidelines by the Security and Exchange Commission , whereby it is specifically mentioned that leveraged ETFs are unsuitable for most investors, who are adept at buy-and-hold strategies. Thus, the Direxion ETF should be used only by those who actively manage their investments and fully understand the risks involved as further detailed in Seeking Alpha's Leveraged ETF Coverage Policy section.

Conclusion

This is the reason why this ETF should be traded carefully, which also signifies that timing is key. In this respect, the ingredients to drive an upside in FAS are present, with the main one being that the worse seems to be over. Consequently, after a market overreaction in the final week of March where it lost over $20 as per the introductory chart, a $16 to $17 rise could bring the ETF back to $80, a support level it has crossed at least ten times since March 2022.

Still, the full tremor of the earnings season has not yet been felt, with Bank of America emulating its Wall Street peers, but for Goldman Sachs, with exposure to M&A-related activities and fixed-income trading, results were more mixed . It is precisely at this stage that using the ETF route to invest is advantageous as FAS also includes BlackRock ( BLK ), the world's largest asset manager which despite seeing first-quarter revenue fall by 10% saw its assets grow to $9.09 trillion as more money got rotated from banks to stocks and bond funds.

Moreover, credit conditions should remain tight with both consumer and business sentiment likely to suffer as the Fed is not likely to pause or pivot any time soon. Therefore, instead of a shallow recession materializing later this year, the outcome can be far worst, again calling for a short-term investment outlook, made possible through FAS.

Finally, when using highly leveraged tools it is better to exit the market honorably even with a tiny gain or a minor loss rather than trying to exercise staying power and suffer from an erosion of value due to the compounding effect.

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