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As the Trump rally fades, blame the banks

The biggest catalyst for the Trump trade has morphed into the biggest liability, as bank stocks have helped thwart what had been a powerful market rally.

Financial stocks dropped again Monday, with banks specifically off about 1.7 percent around midday as measured by the SPDR S&P Bank exchange-traded fund. It was hardly the first time the sector had been a drag on the market in recent days; the bank ETF is off 7.5 percent over the past month.

In all, it's been a startling turnaround for a group that epitomized what President Donald Trump is hoping to do. His agenda of lower taxes, less regulation and more infrastructure spending, coupled with expected higher interest rates, seems tailor-made for lenders.

However, recent political stumbles have triggered unease over whether Trump will be able to get that agenda through an increasingly hostile Congress.

As a result, bank stocks, which soared as much as 33 percent after the election, have tailed off strongly of late.

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It may, however, be more than just worries about how successful Trump will be on Capitol Hill.

One other problem may just be that investors have gotten the whole bank trade wrong from the beginning, according to industry analyst Dick Bove.

In a note to clients Monday, Bove argues that the theory that higher rates would automatically be beneficial was faulty from the onset.

"One issue that never seems to bother investors in bank stocks is checking theories against facts," wrote Bove, vice president of equity research at Rafferty Capital Markets. "And, the market always seems to move on the theories never the facts. This is highly dangerous investing."

His core points:

  • Investors assume that bank stocks can't go up when rates are low for a long period of time, as in 2011-16. Yet earnings surged during the period, establishing records for the past four years.
  • Another misconception is that earnings won't rise when short-term rates are higher than long-term rates. Yet that was the case for nearly half the period from 1966-82, another time of strong earnings growth.
  • The bank trade was based on benefits from a rising 10-year Treasury that would help bank margins. However, Bove points out that rising yields lower the value of bonds that banks currently hold at lower yields. That's particularly the case if earnings don't grow enough to compensate for the loss in yield, which was the case in the fourth quarter of 2016 when bank equity actually fell by $16 billion. "Thus, for bank stocks to rally when rates go up and fall when rates go down is not really economically sound," he said.

In the long-term, Bove remains bullish on bank stocks. However, he believes the short-term enthusiasm was overdone and could cause problems.

"When an industry group ignores facts and operates on unproven theory the risk of loss is great," he said. "This is where we are with bank stocks at present. We are reacting to unproven theory once again. Watch out."

Watch: Oppenheimer still overweight financials