The Aussie market has continued to rally nicely in recent weeks. The two dominant sectors in the market, resources and banking, have both performed well. But behind the rally there is a note of caution…global hedge funds are again increasing their bets against Aussie banks.
The Wall Street Journal has the story…
‘Hedge funds are throwing their weight behind a notoriously risky trade that suggests Australia’s biggest banks, among the most profitable in the world, might be headed for trouble.
‘Rising bad debts, falling earnings and fears of a property-market downturn have triggered a record number of “shorts” on Australian banks, which have long been stock-market darlings because of their high shareholder returns. Short sellers borrow shares from other investors and then sell them in the hope of buying the stock back at a lower price, turning a profit.’
The article goes on to say that bets against the Big Four banks have increased 50% this year, to more than $9 billion.
Aussie banks are among the most profitable financial institutions in the world. For example, in the 2015 financial year, the Commonwealth Bank [ASX:CBA] generated a return on equity (ROE) of 18%. Relative to other global banks, this is an exceptional level of profitability.
The bet against banks assumes ROE will decline in the years ahead. That’s already started to happen. CBA is forecast to see a fall in ROE to around 16.5% this year; and 15.75% in FY17.
That’s why the share price is well off the highs from last year. As you can see in the chart below, CBA peaked at just over $96 in March 2015. It declined to $70, rallied to $86 late in 2015, before falling to test support at $70 a few times again in 2016.
In this urgent investor report, Daily Reckoning editor Greg Canavan shows you why Australia is poised to fall into its first ‘official’ recession in 25 years…
Simply enter your email address in the box below and click ‘Claim My Free Report’. Plus… you’ll receive a free subscription to The Daily Reckoning.
Since May, CBA has rallied up towards $80 again, thanks to the RBA’s interest rate cut. But all the while, hedge funds have been increasing their short bets against the bank, and the sector in general.
[click to open in new window]
You can look at this in a number of ways. From a contrarian perspective, the fact that negative bets are increasing means there is an increased likelihood of a short covering rally taking place on any unexpected good news for the sector, which will push share prices even higher.
On the other hand, the increased bearishness towards the banks reveals a fundamental truth. That is, the sector has had it too good, for too long. Former tailwinds are now morphing into headwinds.
Australian households hold record levels of debt. The banks profit from this. But how much more debt can households carry before it becomes detrimental to the economy and the banks? The hedge funds are clearly betting the answer to that is ‘not much more’.
Unless the RBA cuts interest rates more than expected, it is hard to see the banks rallying to new highs anytime soon. It is also difficult to see the banks falling too hard, given they are a protected species.
From the same article:
‘“It’s a tough trade,” said Andrew Macken, a fund manager at Montgomery Global Investment Management in Sydney, who helps manage assets valued at A$250 million. “Australia’s major banks don’t make good shorts. Even if their profit prospects may look weaker than in the past, they’re still some of the most profitable in the world, competition is limited and they enjoy an implicit government guarantee.”’
If you’re keen on shorting the banks, I would wait until CBA falls below $70. That seems to be a crucial level of support. A fall below there would suggest major problems for the sector…problems that not even lower interest rates could remedy.
But let’s put this ‘high level’ of bank shorting into context. In a list of the most shorted stocks on the ASX, the first bank is ANZ — the 92nd most-shorted stock on the exchange, with 3.09% of its shares ‘sold short’.
Westpac [ASX:WBC] follows in position 101 (2.69% of stock sold short), NAB is at 130 (1.98% of stock sold short), and CBA is in position 133 — with only 1.95% of its stock sold short.
In contrast, let’s have a look at the most heavily ‘shorted’ stock on the Aussie market: Metcash [ASX:MTS].
Metcash is predominantly a marketer and distributor of goods for independent retailer IGA. It’s also a major distributor of liquor, and it owns the Mitre 10 hardware franchise. The market thinks it’s in a bad position due to the ‘Aldi effect’, and also because of the price war between Coles and Woolies.
As a result, a whopping 16.78% of its shares are sold short. That means that short sellers have borrowed a huge amount of shares and sold them onto the market, creating a lot more supply of shares than there naturally would be.
While the MTS share price has had a rough few years — no doubt thanks to the increased selling of the stock among short sellers — it actually bottomed in September last year. The stock price has doubled since the lows!
[click to open in new window]
I recommended the stock for subscribers to Crisis & Opportunity during the December 2015 pullback. Following last week’s break out to new highs, subscribers are now up nicely on the initial buy.
The good news for holders is that the market is STILL heavily short. You haven’t even started to see a short covering rally just yet. If MTS reports better than expected earnings, or reinstates its dividend, you might see larger than expected share price gains as the short sellers scramble to get out.
Or they might finally get a payout if things go south for MTS. But the chart looks pretty strong to me. I wouldn’t like to be short in such a situation.
The point of all this, though, is that there really isn’t much short interest in the banks just yet. Collectively, the market is short less than 10% of the Big Four banks’ shares combined. That’s around 40% less than the short interest in just one stock — MTS.
From a contrarian perspective, that tells you there really isn’t much overall bearishness towards the banks…only that the relative bearishness has increased since the start of the year.
That makes sense given the headwinds faced by the sector. And if the trend continues, it suggests more selling could be on the cards, and that the banks could once again re-test the lows from earlier in the year.
For The Daily Reckoning