KBWB: This Is An Environment To Capture Short-Term Wins (NASDAQ:KBWB)

Main Thesis & Background

The purpose of this article is to evaluate the Invesco KBW Bank ETF (NASDAQ:KBWB) as an investment option at its current market price. This is a sector-specific fund, with a focus on bank stocks exclusively. Importantly, it is heavily weighted towards the biggest banking names, and it is managed by Invesco.

This is a fund I have owned and recommended over time for direct exposure to the U.S. banking sector. A little over three months ago, I reiterated a “buy” rating on this ETF and have seen it perform well since that article:

This is obviously a great move by KBWB since 2022 ended and 2023 began. While I see merit to hanging on at these levels, such sharp short-term gains typically make me cautious. In the case of KBWB, this rings true. I see some macro-headwinds that suggest taking some profit and/or being more selective with positioning is the right move going forward. As such, I am downgrading my rating to “hold”, and will explain why below.

I Still See Merit For Sector Investing

To kick off the review I want to offer some insight into why I think sector investing continues to be relevant. As my followers know, I am a big believer in using sector ETFs to diversify (as opposed to individual stocks and/or just investing in the S&P 500). This includes KBWB and the banking sector, but also areas like Energy, Utilities, Materials, and Real Estate. A big reason why I favor this tactical approach is because the S&P 500 is heavily dominated by not just the Tech sector, but a handful of popular names.

Now, it is worth pointing out that we have been seeing headlines about how the S&P 500 has gotten less concentrated in the past year. This is true and was driven by the poor performance of the Tech sector and “FAANG” stocks. But I think a little clarity is in order. While the dominance of the top holdings in the S&P 500 has waned a bit, their share of that index remains very high and above historical norms. This is illustrated in the following graph:

The message I am conveying is that diversification remains as important today as it was when last year began. Sure, the top holdings have make slightly less of the S&P 500 than they did a year ago. But they still make up a large percentage, in absolute and historical terms. This signals to me that remains disciplined and buying in to sectors that are under-weight in the S&P 500 index continues to make sense. So I see an investment case for KBWB, as well as any number of sector-themed U.S. market ETFs that one can consider.

Banks Are Preparing For Tougher Times

Let’s now talk some headwinds. I mentioned that KBWB has been performing well and that I like it as a way to diversify away from the Tech-heavy S&P 500 index. These sound like great arguments – so why a downgrade to “hold” for this fund?

The answer is partly because of what the big banks themselves are doing. Specifically, they are preparing for more volatile times ahead in the credit markets. I know this because if we look at their credit loss provisions – which is the money lenders set aside for loans that go “bad” (don’t get repaid) – we see the largest U.S. banks are aggressively pumping up those reserves:

This is in sharp contrast to how these companies were responding to the macro-environment in 2021. As the economy improved and credit conditions turned out to be stronger than previously feared, banks began releasing loan loss provisions. Today, they are putting money back into that category.

While that graphic only shows four companies, we should note that these are some of the largest banks in the entire world. Beyond that, they represent almost one-third of total fund assets in KBWB. So it is very relevant for investors in this fund:

This is a case of “follow the smart money”. I see the largest financial institutions taking steps to prepare for a downturn and tighten lending standards. They expect a worsening credit environment and, if that materializes, almost certainly means we will see some corporate earnings pressure. That often leads to a bumpier ride in the stock market, so shifting to a more neutral outlook on KBWB appears well supported right now.

Higher Rates Are Better Right? Sort Of

The next topic I will discuss has to do with interest rates. Generally speaking, banks and lenders earn more profit when rates are higher. But this backdrop comes with caveats. One, it depends on economic conditions. High rates with a worsening economy could mean fewer loans and/or fewer loans being paid back. That is not advantageous. By contrast, a lower rate environment in a strengthening economy could mean less absolute interest per loan, but more loan generation and a high percentage of on-time payments. The net result is that when it comes to big banks and determining whether an interest rate environment is favorable, the answer usually is “it depends”.

It is with this understanding that makes the current situation difficult. The Federal Reserve (and other global central banks) have been aggressively hiking interest rates. The ‘higher rates are better for banks” mantra could thus exist here. The problem is that I’m not sure it does. One reason why was discussed above: banks are setting aside more cash for loan losses. This means they expect more loans to sour, and that will likely curtail future lending in the short-term as well.

The other issue I see is the yield curve. It has been inverting on and off for a while since the Covid-pandemic started as investors grappled with the outlook for the economy. So while the curve inverting at the moment is not new, the level of inversion is worrying. It has reached a level now seen since 1981:

The concern is two-fold. The first is what this means for the economic outlook. Yield curve inversions often signal recessions, and this sharp an inversion is a scary omen. This will pressure corporate America as a whole (if it materializes), including KBWB by extension.

The second issue is that the yield curve inversion exposes a disconnect in the interest rate marketplace. What I mean is that it disrupts the natural order of longer-dated debt charging more in interest. The logic is simple. The longer the time horizon for a loan/credit product, the higher interest it should command. After all, investors want to be paid more for taking on more risk in terms of a longer time horizon. But the inverted curve turns that on its head. Short-term debt ends up with higher rates, meaning that investors are not getting paid appropriately to offer up credit for longer stretches of time. While this doesn’t make logical sense, it is reflective of the outlook for the future – which is negative.

This can be especially painful for banks because their bread and butter is to offer a set rate of interest for short-term deposits and then lend out those deposits at a higher interest rate for long-term loans. An inverted curve makes this more difficult, and leaves the lender will limited opportunities for this yield “pick-up”. As a result, future net interest margins are likely to be challenged for banks across the board. With this in mind, it should be clear why I favor a downgrade to funds like KBWB going forward.

Bottom-line

KBWB has been a real winner of late. As such it probably makes sense to stick with it. If the Fed cools its hawkish language, the economy avoids a deep recession, and credit losses come in under expectations, this is a fund that could continue its rally.

But there are headwinds to this case. The yield curve will pressure bank’s margins, this recession indicator is often accurate, and loan loss provisions will eat in to net profit if they do end up being necessary. This push-pull backdrop tells me now is a good time to either lock in some profit or be more selective with new positions. A 10% pop in just over three months is a strong gain, and I’m not going to chase returns here. Rather, I’ll collect a win, stay patient, and hope to add at cheaper prices. Thus, I believe a “hold” rating is appropriate, and I suggest readers approach the fund cautiously at this time.