AAII Investor Update: Bank Stress Tests and Black Swans

Thursday, March 15, 2012
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 45.6%, up 3.2 points
  Neutral: 27.2%, down 1.4 points
  Bearish: 27.2%, down 1.8 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »


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March 03, 2011

Most of the 19 banks examined by the Federal Reserve passed the new stress test. This examination was designed to see how United States’ largest banks and financial institutions would hold up if another financial crisis were to occur.

The test looked at tier 1 capital. In simple terms, this test checked to see whether a bank’s equity (equity capital plus retained earnings) was sufficient to cover a spike in bad loans. Put another way: Can each bank withstand a sharp rise in defaults among its outstanding loans? The idea is to prevent another situation where money needs to be infused into a bank to prevent it from failing. (Think of “It’s A Wonderful Life,” when Bailey Building and Loan needed a cash infusion from the townspeople because its tier 1 capital was too low.)

The news was viewed as a positive because most banks passed. J.P. Morgan Chase (JPM) actually came out ahead of the Federal Reserve’s press release with an announcement of both an increase in its dividend and a share buyback plan. BB&T (BBT), State Street (STT), U.S. Bancorp (USB) and Wells Fargo (WFC) also raised their dividends. (The Federal Reserve approved plans submitted by American Express (AXP) to raise its dividend but the company has not yet announced an actual increase.) Four firms will have to submit plans to the Fed about how they will improve their capital structures, however. Those firms are Citigroup (C), Ally Financial, MetLife (MET) and SunTrust Banks (STI).

The news led to a rally late on Tuesday, but there was little follow-through on Wednesday. Part of the reason is that the banks were already considered to be on more solid ground now than they were two years ago when the first stress test was completed. As a result, no one was expecting bad news from the Fed. Plus, banking stocks have performed well this year, so there was already good news priced in.

For the stress tests, the Fed assumed a scenario where the U.S. falls into a recession, stock prices drop by 50%, unemployment rises above 13% and both the European and Asian economies experience slowdowns. The scenario did not include explicit behavioral assumptions about what would happen between creditors and lenders. I point this out because such tests are typically based on what forecasters perceive could happen, not on what actually does happen. Panics are often caused by what are perceived as black swan events—low-probability scenarios with the potential to cause significant adverse events. Thus, the stress tests are not a guarantee that the banks can withstand another financial shock.

I’m not typing this to scare anyone, but rather to point out that all risk measures have their limitations. Just because a scenario can be modeled doesn’t mean it will occur or that the outcome would be what forecasters expect. At the same time, investing based on the assumption of a severe macro-economic event occurring can cause you to miss out on market gains, resulting in the purchasing power of your savings being eroded by inflation.

Take confidence in the fact that the Federal Reserve is monitoring the major banks and asking the weaker ones to get stronger. The major U.S. financial institutions are getting stronger, and that’s a good thing. At the same time, realize that all risk assessments have their flaws and that the latest exam provides no guarantee that another “too big to fail” situation won’t occur.

Risks always exist, but understanding when the long-term opportunity for reward outweighs the potential for a loss has long been a successful recipe for building wealth.

Model Portfolios Updated on AAII.com

Several transactions were made in the Model Shadow Stock portfolio. Three stocks were sold: Paragon Shipping (PRGN), because it violated earnings probation; Lithia Motors, Inc. (LAD), because its market capitalization exceeded the portfolio’s size limit; and SureWest Communications (SURW), because it agreed to be acquired by Consolidated Communications. The proceeds from these sales were used to buy three stocks: Ducommun Inc. (DCO), Medical Action Industries (MDCI) and Sterling Construction Company (STRL).

Last month, the Model Shadow Stock Portfolio gained 6.1%. The portfolio beat both the Vanguard Small Cap fund (NAESX), which gained 3.2%, and the DFA US Micro Cap fund (DFSCX), which gained 1.9%. For the year, the Shadow Stock Portfolio is now up 17.2% compared to 10.4% for the Vanguard Small Cap fund and 9.0% for the DFA US Micro Cap fund.

The Model Mutual Fund Portfolio gained 2.4% in February. This compares to the Vanguard Total Stock Market fund’s (VTSMX) gain of 4.3%. For the year, the Model Mutual Fund Portfolio is up 7.9%, while the Vanguard Total Stock Market fund is up 9.6%.

The Model ETF Portfolio gained 2.4% in February, topping its 80% SPDR S&P 500 ETF (SPY)/ 20% iShares MSCI EAFE Index ETF (EFA) benchmark, which gained 4.6%. For the year, the Model ETF Portfolio is up 9.0%, while its benchmark is up 9.4%.

More on AAII.com

The Week Ahead

The initial group of first-quarter earnings reports will be issued next week with 11 S&P 500 member companies reporting. Included in this group are Adobe (ADBE) on Monday, Oracle (ORCL) and Tiffany (TIF) on Tuesday, Discover (DFS) on Wednesday, and FedEx (FDX) and Nike (NKE) on Thursday.

The week’s first economic report will be the National Association of Home Builders’ March housing market index. Tuesday will feature February housing starts and building permits. February existing home sales will be announced on Wednesday. Thursday will feature the February Leading Indicators Index. February new home sales will be announced on Friday.

Federal Reserve Chairman Ben Bernanke will speak publicly on Tuesday. Other Federal Reserve officials speaking publicly include Dallas President Richard Fisher on Monday, Minneapolis President Naryana Kocherlakota on Tuesday, and Atlanta President Dennis Lockhart and St. Louis President James Bullard on Friday.

The Treasury Department will auction $13 billion of 10-year inflation-adjusted securities (TIPS) on Thursday.

AAII Sentiment Survey

Bullish sentiment rose to a five-week high as bearish sentiment declined in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stocks prices will rise over the next six months, increased by 3.2 percentage points to 45.6%. This is the highest level of optimism since February 9, 2012. It is also the 12th consecutive week and the 13th out of the last 14 weeks that bullish sentiment has been above its historical average of 39%.

Neutral sentiment, expectations that stock prices will fall over the next six months, declined 1.4 percentage points to 27.2%. This is a 13-week low. It is also the sixth consecutive week that neutral sentiment has been below its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 1.8 percentage points to 27.2%. This is the 11th consecutive week and the 12th out of the last 13 weeks that bearish sentiment has been below its historical average of 30%.

The difference between bullish and bearish sentiment, the bull-bear spread, is 18.4 percentage points. This the 11th consecutive week that the bull-bear spread has shown a positive, double-digit differential, the longest such streak since May-August 2005.

Continued signs of an improving economy and rising stock prices are giving AAII members reasons to stay optimistic about the short-term outlook for stock prices. Tempering this optimism are concerns about the slow pace of economic growth, rising gas prices, and Europe’s sovereign debt problems.

This week’s special question asked AAII members how much progress they thought was being made in resolving the European sovereign debt crisis. The majority of respondents thought the European Union was simply buying time instead of making true progress. A notable minority of respondents thought real progress on a solution was being made, however.

Here is a sampling of the responses:

  • “Enough progress has been made to kick the can down the road for a while longer, but not enough to prevent an eventual meltdown.”
  • “Not much progress. I think that the day of reckoning is just being put off.”
  • “Very little, because they are continuing to kick the can down the road, instead of just dealing with the problem.”
  • “No long-term progress; just delaying the inevitable.”
  • “Progress is being made—and slow and ugly it is.”

» Take the sentiment survey

Have a happy St.Patrick’s Day (and wear something green),

Charles Rotblut, CFA
AAII Journal Editor