Should you buy the dip?

Stock markets have started the new week with a rise as the banking crisis shows signs of calming down, at least temporarily. However, these crises are characterized by moments of serenity between new nasty surprises.

In this post, we talk about how the banking drama has continued with the collapse of Credit Suisse and increased intervention in the faltering sector and how all this affects the economy. Finally, a little reflection on whether to buy shares in the current dip.

The bank thriller continues

The tension in the banking sector has continued. Over the weekend, Swiss banking giant Credit Suisse was swallowed up by rival UBS at a price of CHF 3 billion. Equity investors have practically lost their money, but at least judging by the green reaction of the stock markets, the news was received positively by the market.

The 99% fall of the old banking titan from its 2007 peak is a healthy reminder of the risks of investing in equities. Eventually, even the best companies run into problems and slowly wither away. Credit Suisse faded loudly, even though the decline lasted 15 years. Apparently, the bank run was too much, as the initial central bank support was not enough to solve the crisis. Under the agreement, UBS will take the first 5 billion of any losses, with Swiss taxpayers taking the next 9 billion. The distribution of potential losses suggests that the bank still has a lot of unresolved bombs that the less headline-grabbing, more stable UBS is now having to dismantle. However, this is a typical way of running a crisis bank by dumping it in the care of a stronger bank, which then reorganizes or splits up the operations.

The unpleasant thing about banking crises is how easily they spread around the world. The drama that started with Silicon Valley Bank doesn't seem to be spreading so far, and it's a wonder Deutsche Bank has so far stayed out of the headlines. With small banks calling for more comprehensive deposit insurance, central banks pulling out the hoses and Warren Buffett in talks with the White House, there is a behind-the-scenes push to contain the spread of the crisis. At the time of writing, major US banks, led by JP Morgan, were considering bailing out troubled bank First Republic.

By the way, there is a touch of history here, because in 1907, JP Morgan's founder, J.P. Morgan, orchestrated the banks together to avert the financial crisis of the time. This crisis was also the starting point for the creation of the Fed.

The small bank index has plummeted 45% from its peak in just over a year, reflecting investors' mistrust of small banks susceptible to bank runs.



As I have often said, bank crises can ultimately be solved with money. It’s a whole another question how much other banks, central banks or taxpayers will end up having to support the banks. However, there is a manual for dealing with the banking crisis, if only there is the political will. It would be strange if the most watched sector in the world were allowed to go into crisis. Of course, this statement may age like fine milk in a slippery world, but I dare to say it.

At least the Fed's net liquidity has started to gallop upwards. This has usually been a positive sign for equities in recent years, but this time the Fed's ballooning balance sheet is a sign of the banks' distress. Expensive emergency loans are not taken out for the fun of it, because it gives the authorities a clue as to which banks are in trouble. The swelling of the balance sheet by hundreds of billions by last Wednesday alone suggests that banks' thirst for money has not been small in the deadly bank run freeze.



The longer the crisis continues, the more the question of its impact on the economy arises. This graph of Nordea reflects banks' willingness to lend and economic downturns. Everyone can ask themselves whether the current climate of uncertainty and the bank's willingness to lend will increase. If banks squeeze credit, the economy takes a hit because the economy runs on credit and debt. Without a loan, big purchases such as a car or a home are quickly put on hold and business investments come to a standstill.

In the US, for example, small and medium-sized banks account for 40% of all loans and as much as 70% of real estate loans. Incidentally, the concentration of small banks' lending in the stagnant real estate sector is probably part of the reason for the beating they have received.



If the budding banking crisis takes away banks' willingness or ability to lend, the recently red-hot economy could cool down rapidly. Then stocks are again looking at a hard landing scenario. To some extent, the banking crisis has a silver lining, as it can take inflation with it. But the banking crisis is so unpredictable in its escalation that this medicine will quickly bring new, worse ailments to replace it.

Financial conditions have tightened rapidly in recent weeks, with no junk bonds sold in the US, for example, for almost three weeks. For indebted firms, the prolonged situation is a drag. This graph shows the US and eurozone monetary indices. In the eurozone, the situation is actually even tighter than in the euro crisis. I hope this is not a hint of things to come.



The US Federal Reserve has an interest rate meeting this week where another 0.25% rate hike is expected and last week the European Central Bank raised its policy rate by 0.5%. In other words, for now inflation remains central banks' public enemy number one.

Interest rates have fallen sharply in the market. The interest rate on the US two-year bond has fallen below 4%. Even the 10-year one, which reflects a more longer-term inflation and economic growth outlook, has slipped to 3.5%. The fall in interest rates may only be a momentary pressure as investors move their money to the safety of the world's safest bonds. However, if this lasts it will signal a sharp deterioration in the economic picture in the eyes of investors.
 
Should you buy the dip?

Surely every investor has been wondering over the past couple of weeks whether to buy the current dip in equities or wait for a bigger storm to escalate. I don't know nor does anyone else know where stocks will go in the near future, but I can offer some thoughts.

Bank shares have fallen sharply. In some cases, such as the financially sound Nordea, there has been talk in the media about how not all bank shares should be hit. This graph shows the share price of the major Nordic banks relative to equity per share. Nordea was already priced at 1.4 times the equity, now less than 1.2 times.

 
However, when looking at all banks, it is worth noting that a fall in interest rates will reduce banks' future interest income. A recession would increase their credit losses. And, perhaps worst of all in the long term, is the potential for increased regulation. Crises usually lead to further regulation.

While in the US stocks have not fallen much on lower earnings forecasts, in Europe you can again find discount tags on the stock market. The forward-looking P/E ratio of the Helsinki Stock Exchange has fallen to 12.5. In terms of earnings multiples, the Helsinki Stock Exchange has been this cheap since last fall, at the bottom of the COVID crisis, the euro crisis and the financial crisis. It would be a wonder if this weren’t a good place to buy. Assuming, that the results hold up reasonably well.

 
Similarly, the more stable P/B ratio is now 1.8. That too is on a par with last fall, although not quite as attractive as in previous crises. Of course, the different message of the two is that the average return on equity for Helsinki Stock Exchange firms has improved in recent years. Whether it will last, time will tell. All in all, the Finnish stock market is certainly not expensive, and buying shares in such situations hasn’t usually been the worst idea in the world. It’s difficult to make excess returns, especially in large companies, unless you buy them in a crisis. That's not to say that there aren't even better places to buy, but you can already find reasonably priced stuff on there.

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