Moody’s warning on US banks is a wake-up call for investors.

Moody's warning on US banks is a wake-up call for investors.

U.S. Bank Stocks Caught off Guard: A Wake-Up Call for Complacent Investors


In a surprising turn of events, U.S. bank stocks saw a sharp decline this week, catching traders in the options market off guard. This raises concerns regarding whether investors in this sector have grown a little too comfortable, especially considering the financial crisis only a few months ago.

The drop in U.S. bank shares occurred after credit ratings agency Moody’s downgraded the credit ratings of several U.S. regional lenders and placed certain banking giants under review for potential downgrade. Moody’s warned that lenders would face challenges in generating profits due to high interest rates, rising funding costs, and the possibility of an impending recession. The agency also highlighted the risk of some lenders’ exposure to commercial real estate.

Interestingly, this warning seemed to catch many investors off guard. Just a day prior, options traders’ expectations for short-term volatility in two major sector exchange-traded funds (ETFs) – the SPDR S&P Bank ETF (KBE.P) and the SPDR S&P Regional Banking ETF (KRE.P) – hit their lowest level since the collapse of Silicon Valley Bank in March. This lack of concern among investors regarding the sector’s outlook was evident in the data from Cboe’s options analytics service, Trade Alert.

However, the implied volatility of KRE.P’s options saw an increase from 28.9% on Monday to 31.1% on Tuesday. Despite this rise, the current volatility level of 30.7% still remains significantly below the peak of 82% witnessed in March. This suggests that investors have seemingly come to terms with the risks associated with the sector and were not focused on taking defensive positions. This could be attributed to the fact that they may have already reduced their exposure to banks or were not overly concerned about the prospect of further bad news.

Steve Sosnick, the Chief Strategist at Interactive Brokers, noted, “There’s not nearly as much risk being priced in.” As of Wednesday, there were approximately 1.5 put options open against each call option, indicating that positioning is less defensive than 80% of the time over the past four years. This is a stark contrast to March when there were more than four put options open against each call option, according to data from Trade Alert. In options trading, calls represent the right to buy shares at a fixed price in the future, usually indicating a bullish bet on the shares rising, while put options give the right to sell shares, reflecting a bearish or defensive view.

Although the S&P 500 Banks index has experienced a 3% decline this year compared to the 17% gain of the broader S&P 500 index, it has seen a significant recovery of approximately 17% from the multi-year lows reached in early May. David Wagner, Portfolio Manager at Aptus Capital Advisors, stated, “This is more of a shot across the bow for those investors that are getting complacent within this space,” referring to the Moody’s ratings changes.

While the collapse of three mid-sized U.S. banks earlier this year and record deposit outflows from smaller lenders initially sparked concerns about the broader banking industry, the absence of further bank failures and the resilience of economic data have helped bolster investor sentiment since May.

However, risks still linger, including exposure to the commercial real estate office sector, which has been impacted by ongoing pandemic vacancies and high interest rates. Additionally, the increasing cost of retaining deposits remains a concern. Analysts believe that the risks associated with impending new regulatory capital hikes may be underpriced, potentially resulting in short-term capital pressure for some lenders.

Despite these challenges, some investors argue that the major risks are primarily short term. Brian Mulberry, Client Portfolio Manager at Zacks Investment Management, which holds stocks in several major lenders, expressed optimism for the future, stating, “In the near term, there are reasons for caution about banks in general, and we have made changes where appropriate. However, as interest rates go higher, the more pressure it puts on banks’ profitability. Even so, we do not see this as a solvency issue where the entire banking system will collapse.”

In conclusion, the recent decline in U.S. bank stocks serves as a wake-up call to complacent investors who may have overlooked lingering risks in the sector. While some short-term challenges and uncertainties remain, it is crucial for investors to maintain a cautious approach and carefully evaluate the potential impact of factors such as commercial real estate exposure, deposit costs, and impending regulatory capital hikes. By doing so, investors can navigate these risks while also recognizing the long-term growth prospects that exist within the banking industry.