There are many striking parallels between the current economic and market landscape and 2008 which was the most devastating year for investors since 1929. Essentially, that bear market wiped out more than an entire decade's gains.
Some of these parallels include the Federal Reserve tightening despite a slowing economy, sky-high oil prices impacting consumer spending, and a valuation reset that seems poised to turn into an earnings decline.
However, there is one major difference - the health of the banks. In 2008, the banking system was at the heart of the crisis due to excessive speculation and leverage. This compounded the economic pain as liquidity and insolvency issues led the banks to freeze their own lending activity which threatened the collapse of the entire system.
Today, the banks are in a much different position. This was made evident by the results of the Fed's latest stress test which resulted in passing grades for all the major banks. In its conclusion, the Fed said that the banks could easily endure a severe recession and keep functioning through it.
And, it's also clear from their earnings report which has been pretty resilient and a far cry from 2008 when investors had to hold their breath every time a bank reported.
This is due to higher capital requirements, better quality reserves, and an aversion to speculative activity. Not coincidentally, a few increased their dividends as this is a condition of the stress tests. Interestingly, the Wall Street-centric banks like Morgan Stanley (NYSE: MS) and Goldman Sachs (NYSE: GS) hiked by the most, while Main Street-centric banks were much more subdued with their dividend hikes.
The U.S. Federal Reserve is due to release the results of its annual bank health checks on Thursday. Under the "stress test" exercise, the Fed tests banks' balance sheets against a hypothetical severe economic downturn, the elements of which change annually.
The results dictate how much capital banks need to be healthy and how much they can return to shareholders via share buybacks and dividends. It's also especially germane given that we are facing the highest level of recession risk since the Great Recession.
And, it's been a tough environment for bank stocks. The group outperformed in the first 3 months of the year as it benefited from strong economic growth and a steeper yield curve. However, these catalysts have been neutered. Now, the banks are dealing with the potential for a recession which would likely lead to spiking defaults and a flat yield curve which makes the business of taking deposits and lending less profitable.