Bank stocks ... It's the yield curve

Australia’s “big four” – CBA, Westpac, ANZ and NAB – have far exceeded the overall market over the past two years.

To some people, this has raised enormous concerns about their future potential. Has their risk increased due to the run-up in prices? Are they likely to fall back to the pack?

It is said that the big four banks make $1,460 in profit from each Australian per year.

This makes our banks the most concentrated and the most profitable in the world.

In this article I assess a few of the hard hitting facts about our banking sector and come to some conclusions about the allure/risks of any investment in these companies.

Firstly, it is important to have a quick look back and realise where we have come from. Two things should be obvious from the chart above: 1) the big four have dominated against the broader market; and 2) the banks are all highly correlated and tend to move closely together.

But … 20% outperformance from each of these banks is monumental.

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What drives the banks?

Typically, broker analysis would simply state that the drivers are XYZ (inflation hedge, corporate lending, profit margin expansion, etc.). Yet, in our advanced world, we can do a lot better analysis than this.

Using the price data from June 30, 2001 to June 30, 2011, I have established the correlations between the banking sector (sourced using the Financial GICS, excluding Property) and a variety of economic variables. The results were very surprising indeed.

It turns out that the drivers of the banking stocks are very different to what we often read about. What caught my eye was that actual interest rates, unemployment, economic growth and house prices had very little to do with banking sectors share-price movements.

However, that doesn’t mean we are without any insights. From the above, two clear drivers were:

• The yield curve.
• Motor vehicle sales.

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Yield curve changes

Yield curve data is freely available on the Reserve Bank’s website (www.rba.gov.au/statistics) and tells you a lot about banking shares. Realistically, the yield curve is just the rate that the Government pays to borrow money. In simpler terms, it can be seen as a snapshot of where the market believes interest rates are going over the course of 10 years. If the collective opinion between now and tomorrow is that rates will go up more than previously expected, then this shift tells us a lot about what banking stocks might do.

If we analyse the chart, it is difficult to see the resemblance between bank shares (which have a positive slope) and yields which have been trending sideways or down. However, upon closer inspection, the periods from 2005-2008, 2009-2010 and 2012-13 all experienced increases at the same time as banking shares made their most impressive gains.

There are reasons for this, especially because an expanding yield curve shows that people are more confident. Therefore, if the five and/or 10-year yields are increasing, then banking shares could be expected to increase; and vice versa. Currently, the yield curve is experiencing a gradual shift upwards, which is a positive sign that banking shares will do well in the short term.

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Motor Vehicle Sales

It doesn’t seem right to think that motor vehicle sales would have any great impact on banking shares. In reality, the banks have nothing to do with cars apart from some minor lending. However, car sales are a sign of confidence and have a great impact on whether people will begin spending.

What you need to know is that if motor vehicle sales are increasing, then bank shares are also likely to be increasing.

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In Summary

Banking shares can be a great asset for your core portfolio. However, they are not always the low-risk option that people seek out. The truth is that banking shares are often a dividend yield play for most everyday Australians. If you want to assess banking stocks it would be prudent to add motor vehicle sales and the yield curve to your analysis.

This article was first published in the investment newspaper, Mr-Market. Scott Dixon is the founder and chief editor, and specialises in providing investment insights.