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PROFIT CENTER
I remember when being short the Dollar was one of the most crowded trades late last year.
That’s when I began covering the currency at $96.50 and said that an uptrend was about to unleash, and so far that idea has turned correct.
Today, the most crowded trade in history (at 82% concentration) is being long global semiconductors.
Everyone loves to throw around that “picks and shovels” analogy, but banks are really the only ones that apply it in the best way.
After the biggest US banks reported their quarterly earnings yesterday, that became clear.
Record revenues, profits, and momentum for:
Goldman Sachs
Bank of America
Citigroup
J.P. Morgan Chase
That’s great news…
So why is the XLF Financial ETF underperforming other hotter areas of the market?
Because anyone who understands the capital cycle knows this:
Record equity issuance, IPOs, and leveraged positioning are the profit centers behind these record earnings
Which really means one thing,
The supply of cheap capital is ample, and risk-taking is also at an all-time high during a cycle where more and more companies continue to issue expensive shares, lever up their balance sheets by issuing debt, and IPOs further spikee available equity supply.
Essentially, there’s an oversupply of equity capital going into a sector where oversupply of inventory and capacity is starting to brew. This is when AI winners become losers.
Now that being long AI-related names is the most concentrated bet in the world, and the big banks are driving record profits from the madness.
It’s time to uncover:
The Story Bank Earnings Aren’t Telling You.
CHART OF THE DAY
Household wealth in the United States is now close to 35% concentrated in equities.
Which is not only a normal cycle, but also an all-time high.
It makes sense when you consider how sophisticated people have become in the stock market, and how priced out they are from other asset classes.
However,
This is also a time when everyday people are aware of investing into hot IPOs, leveraged ETFs, and perhaps not the best products to help their futures.
ARE YOU COVERED? —>
This matters because it’s one of the reasons behind the record revenues generated in the prime brokerage arms of these banks.
People are going all in, and leveraging up while at it as well.
All of this increases the upside for the HALO and real economy rotation.
MASTERS OF THE UNIVERSE
Over $4.1 trillion of new capital has been issued in the S&P 500.
That’s roughly 6.0% of the entire index’s market capitalization, and I know that may not sound like much at face value.
But,
When you realize what this really means, it’s really one of the biggest signals when it comes to future returns.
To save time, you can prompt your AI model of choice to search for the following:
A list of stocks that traded at expensive multiples, issued shares through follow-on offerings, and saw their stock prices decline thereafter
The list is extensive, and it’s the exact setup behind the S&P right now.
S&P 500 Earnings Yield, Offside Capital
The problem is not the level of issuance, but the timing of it.
Because the S&P 500 now trades at a P/E multiple of ~32x, its earnings yield has fallen to roughly 3%.
Notice what happens when the yield approaches or falls below the inflation threshold.
Typically a lost decade scenario comes about, where capital is not as ample or cheap, and these banks see declining revenues and earnings.
In a nutshell:
Equities trade at aggressive valuations
6% of the market cap is being issued through new capital
Underlying yields are below inflation
The mechanics of this deal just don’t work, it is the opposite of buying back stock or paying dividends when valuations are cheap.
Which is value constructive.
Issuance at all-time high valuations are value destructive.
Banks don’t care, their incentive is to feed markets what they ask from them, and right now that’s hot IPOs and expensive shares.
Here’s a quick report put together after the earnings figures came out, hopefully it sheds further detail into the state of affairs we are currently in.
Now let’s get into segmented revenues specifically.
There are three main ways that investment banks generate revenue, and where each of them is as a percentage of the whole matters a lot in gauging market extremes:
Net Interest Income (NII) from lending products and financing
Capital Markets and Wealth Management (issuance, trading, and prime brokerage)
Investment Banking fees (IPOs, M&A, restructurings)
These are listed in order of defensiveness to cyclicality.
Meaning when banks make most of their earnings from NII, the economy is headed into defensive mode along with markets as the appetite for risk-taking is low.
Then,
When investment banking fees accelerate, it means the business cycle is on the rise and approaching hotter levels.
Being in either extreme doesn’t guarantee a bottom or peak, but it does signal caution ahead.
This curve does a pretty good job at explaining where we are in the cycle for bank earnings.
In 2022-2023, most of this curve would have been concentrated around the NII and fixed income trading edge, signaling a defensive state of the market post the drawdowns that we experienced then.
Today, it’s different.
Most of the earnings are concentrated around Investment Banking fees and Equities trading/financing.
By itself, this means very little.
But,
Combined with a new historical level of concentration into one trade, a record 6% of market cap issuance within the index, and all-time high margin debts for household wealth…
You have a setup that most resembles previous market peaks.
When it all turns, nobody knows.
Our job is not to time the market turn or rotation…
Our job is to look where opportunities offer better risk/reward ratios and earnings yields!
WHAT’S THE TRADE?
After filtering by forward EPS growth and earnings yield, it becomes pretty clear that my HALO and real economy thesis is getting ready to pay in the coming months.
Specifically:
Retail-Wholesale
Transportation
Automotive stocks
To no surprise, that’s exactly where the Offside Portfolio has been focused on apart from the overweight software exposure to counteract any rotation out of AI-related plays.
As the breadth rotation continues to gain momentum, I suspect these areas will easily deliver double-digit upside.
Especially in the retail and transportation side of things, aided by the tail event around Hormuz reopening.
Lower fuel costs, normalized lead times, and a more confident consumer around these issues can pay off big.
You have the setup here.
But,
Premium Members will receive the actual trades and structure to profit from it.
Subscription prices go up this Friday to $249.99/month.
A Final Note
COMING UP NEXT
As PPI and retail sales data hits the tape this week, I suspect a lot of these ideas will start to concentrate around a handful of specific stocks.
I will break down these datapoints and lead you down a very simple and short rabbit hole of opportunities to uncover.
The result will be a clear way to play these rotations and outperform the overly concentrated bets in AI.
In the meantime, here’s the latest take on Hyperscaler capex spending by Goldman Sachs, ideal to watch along with my breakdown of AI financing headwinds ahead of the earnings season:
Until next time,
OFFSIDE RESEARCH
Against the Tape, Ahead of the Curve.