Is Deutsche Bank Another Bear Stearns?

Major Moves 

Deutsche Bank AG (DB) announced that it would lay off 18,000 workers worldwide and close its equity trading department. In a scene right out of the 2008 financial crisis, employees of the bank were seen streaming out of the London offices (the U.K. operations are bearing the brunt of the equity firings) and into the nearby pub.

The reaction to layoffs is not always negative – sometimes a trimmer organization means that margins will improve, and a premium is deserved. However, the Deutsche Bank firings are another sign of a troubled organization that never recovered from the one-two punch of the 2008 financial crisis and the 2010 through 2012 Greek debt crisis.

From a technical perspective, Deutsche Bank stock had been flirting with a breakout above resistance at $8 per share on Friday. However, it's clear that the stock is heading back toward its lows. The chart below is Deutsche Bank's German stock, denominated in euros, which I think is an even better illustration of the whipsaw over the past two trading sessions.

Is there something to learn from the Deutsche Bank collapse? In my opinion, investors should watch the troubled banks in Europe very closely. Deutsche Bank isn't the only bank with problems – it's not even in the worst shape. It's possible that the European banking sector's instability could bleed over into the U.S. banking system as well.

Rates are very low, which may help motivate borrowers, but it also means that the banks have very lean margins between their borrowing costs and interest income from their loans (the yield spread). I don't want to mislead by comparing this to Bear Stearns in 2008, but Deutsche Bank's capitulation is a noteworthy development that should make investors more wary about the financial sector in general.

Russell 2000

Although the large-cap indexes are at new highs, small caps continue to underperform. For example, the Russell 2000 small-cap index was down twice as much as the S&P 500 today as it continues its bounce off the resistance level of its current channel.

As you can see in the following chart of the iShares Russell 2000 ETF (IWM), the fund has been drifting between $146 and $158 per share, never quite completing its own inverted head and shoulders pattern. Support at $146 still looks good for new buyers, and I expect that strong resistance level to weigh on investor sentiment if it remains intact.

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Risk Indicators – Market Breadth

The S&P 500 has retraced some of the gains from last week today, but volatility is still relatively low. On the surface, this seems encouraging. However, if we want to evaluate how strong the rally has been, an interesting study is to compare the S&P 500, which is weighted based on market capitalization, versus the S&P 500 on an equal-weight index.

Right now, the S&P 500 has the most exposure to the largest companies (the winners) and the least exposure to the smallest companies (often the losers or riskier stocks), so if the biggest companies are doing very well, then the index will rise even if the smaller companies are doing poorly. This can happen when investors are rushing into stocks that are using cash reserves to conduct buybacks or are using larger firms as a defensive strategy against market volatility.

An equal-weight index measures the average performance of the S&P 500 as if each stock, no matter how large, is 0.20% of the index. If the equal-weight index is underperforming the regular index, then we can assume that market breadth is weak.

The last few times the S&P 500 got to a new high while the equal-weight index showed weakness were January 2018, September 2018, April 2019, and July 2019. This means fewer stocks are driving the rally, which makes short-term reversals more likely. As you can see in the following chart, this round of weakening breadth has existed since late February, so investors should be a little concerned.

Don't mistake information like this for a "sell signal" – instead, it's like reading the weather forecast. If there is a rising chance of precipitation, take an umbrella when you leave for the office, but don't quit your job. In my opinion, that means traders looking at a hedge against sudden volatility once earnings start to stream in this month will likely be glad they did.

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Bottom Line – Cautious Before Earnings

I hate to leave this issue of the Chart Advisor on a sour note, but expectations for rate cuts and earnings are already so high, I feel like there is some unbalanced risk exposure to the downside in the short term. I suppose the bright side to a situation like this is that, if I am right, there should be great opportunities to buy back in at support in a few weeks.

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