Stock Market Could Plunge On 'Very High' Risk Banks – Investopedia (blog)

America’s big banks are the linchpin of the financial system and, in a replay of the 2008 financial crisis, threaten to pull down the entire stock market because of the “very high” risk they pose right now, according to veteran bank analyst Richard Bove of the Vertical Group, in comments he made on CNBC. As the big banks approach the third-quarter earnings season, Bove warns that their profits cannot possibly justify the 12% rise in their share prices during the past four weeks, as evidenced by gains in the SPDR S&P Bank ETF (KBE).

Third-Quarter Earnings Outlook

JPMorgan Chase & Co. (JPM) and Citigroup Inc. (C) are scheduled to report third-quarter earnings on Thursday, while Bank of America Corp. (BAC) and Wells Fargo & Co. (WFC) are due to report on Friday. Per Thomson Reuters data reported by Yahoo Finance, consensus third-quarter EPS estimates for these banks are, with comparisons to the same quarter in 2016: JPMorgan Chase, $1.66, up 5.1%; Citigroup, $1.32, up 6.5%; Bank of America, $0.46, up 12.2%; and Wells Fargo, $1.03, unchanged.

Warning Signs

Bove warns that bank profits and stock prices will plunge if loan growth, margins and the economy do not improve sufficiently. Indeed, he says that nearly all the big banks are “flat to lower in growth” than they have been in the last few years, across almost all their products.

This comes as other investors worry that the market is seeing a short-term “melt-up” before plunging, according to Barron’s. In fact, Jeff deGraaf, chairman and head technical analyst at Renaissance Macro Research LLC, tells Barron’s that market melt-ups tend to be the most frenzied as they reach a climax. Portfolio managers afraid of being left behind are chasing ever more overvalued stocks, he notes. (For more, see also: 5 Forces Fueling the Market’s ‘Risk Rally.’)

A worrisome indicator to deGraaf is the purchasing managers’ index (PMI), which measures the health of the manufacturing sector. The value of 60 registered in September puts the PMI in a lofty range. It typically has signaled, during the last 50 years, an impending drop of about 4% in the S&P 500 Index (SPX) in the six months afterward, deGraaf tells Barron’s.

Meanwhile, the spread between the Fed Funds rate and the yield on the 2-year U.S. Treasury Note suggests to de Graaf that further rate hikes by the Fed will be upcoming. He says that the equilibrium level of the former normally equals the latter, but the respective rates right now are 1.125% (the midpoint of the Fed’s target range of 1% to 1.25%) and 1.5%.

In the later phases of an economic cycle, a shift to less-easy credit typically terminates the expansion, Barron’s notes. Looming on the horizon is the Fed’s pledge to begin shrinking its $4.5 trillion balance sheet, thereby withdrawing liquidity from the financial system. (For more, see also: Stocks Face “Nasty Shock” From Fed-Created Bubble.)

Heavy Dilution

Meanwhile, both Citigroup and Bank of America are still recovering from the 2008 crisis, the Wall Street Journal reports. Shares of these two banks are down, respectively, 86% and 51%, since early 2007, the result of massive share dilution, the Journal says.

To pay back their respective $45 billion federal cash infusions from the TARP program, both banks aggressively issued new shares, with Bank of America doubling its shares outstanding from the end of 2007 to the end of 2010, while Citigroup increased its shares outstanding by about six times, the Journal indicates.