Overconfident traders wind up on the wrong side of a $30 billion bank bloodbath

Patrick BatemanAmerican Psycho screengrabWhen investing in the stock market, overconfidence can come back to bite you.

It’s good to invest with conviction. Just not too much conviction.

That lesson rang true on Friday, as overconfident traders found themselves on the wrong side of a massive bank selloff, which, at its worst, erased more than $US30 billion in market value.

The weakness was spurred by earnings reports from three of Wall Street’s biggest banks: JPMorgan, Wells Fargo and Citigroup. Despite sales and profit results that largely met analyst expectations, the three firms slipped more than 1%, dragging broader financial indexes lower.

Wells Fargo and Bank of America declined at least 2.3%, while the KBW Bank Index dropped 1.3% as all but one of its 24 stocks fell.

While the exact source of weakness is difficult to pinpoint, JPMorgan’s fixed-income sales and trading revenue did come in under estimates.

The sharp selling in banks caught many traders off guard, judging from the lack of downside protection being purchased heading into the reports. Short interest on an ETF tracking financial firms in the S&P 500, a measure of bets on financial share prices dropping, sat at about 0.7% of shares outstanding before Friday. That was roughly one-third of the measure’s average over the past year, according to IHS Markit data.

That lack of hedging is even more surprising when you consider that the ETF’s underlying index sits just 1.5% from its bull market high.

Short interest vs price (1)Business Insider / Andy Kiersz, data from IHS MarkitShort interest in an ETF tracking financial stocks has fallen as the underlying index has climbed near historical highs.

That’s not to say the outlook for bank stocks is particularly dismal. It’s still a sector favoured by many investors, who see it benefiting from looser regulation and higher interest rates. BlackRock chief equity strategist Kate Moore told Business Insider that another part of the appeal is how under-owned the sector is.

It’s also entirely possible that investors will use short-term weakness in financial stocks to buy shares at a discount. The buy-the-dip cycle has played out many times throughout the eight-year bull market, showing repeatedly that there are still bulls out there looking to boost positions.

Further, IHS Markit equity and credit markets analyst Simon Colvin told Business Insider on Thursday that the reluctance of traders to short may also be “driven by the fact that banks have aggressively raised their dividends in recent months which adds to the cost of shorting.”

Regardless of the reason, holders of bank shares are having a tough day. But with firms like Bank of America and Goldman Sachs set to report earnings next week, the sector should have an opportunity to right the ship — and make some money back for its proponents.

NOW WATCH: Money & Markets videos

Want to read a more in-depth view on the trends influencing Australian business and the global economy? BI / Research is designed to help executives and industry leaders understand the major challenges and opportunities for industry, technology, strategy and the economy in the future. Sign up for free at research.businessinsider.com.au.