naked capitalism

Bank stocks enjoyed a nice bounce from the fact that UBS announced a first quarter loss equal to 5% of Switzerland’s annual GDP. The logic evidently was if things are that bad, they can’t get much worse, ergo, a bottom must be at hand. But this credit contraction has produced a number of head fakes (remember, when banks reported scary writedowns for the third quarter 2007, the entire market rallied on the belief that the purging had been so extensive that the financial firms had put the past behind them.

Neil Hume in the Financial Times argues that there are plenty of reasons to be cautious about the implicit upbeat forecast for banks. While the discussoin focuses on the UK, many of the observations apply to the US too:

At first glance, the sector, which has fallen by 22 per cent in the past year and has seen several constituents shed 40 per cent of their market value, appears cheap.

Domestic banks – this excludes Standard Chartered and HSBC, which make most of their profits overseas – trade on a prospective price earnings ratio of around 7.6 times earnings, according to estimates from Goldman Sachs.

However, it has been cheaper. In the period before the last recession in the UK, the sector was trading on a forward multiple of 5-6.

In any case, p/e ratios are of limited value when there is no visibility of earnings. And for a number of reasons that is certainly the case at the moment.

For example, profits are very sensitive to the cost of funding. The gap between base rates and the three month sterling inter-bank rate has doubled since February and predicting where it will be in two months time is a mugs game.

By the same token, no-one knows when the securitisation market will fully re-open for business. If it remains effectively shut lending will have to be reined in further.

On top of that there is no clarity on bad debt charges, which could rise sharply if the economy and the housing market continues to slow.

Further losses on portfolios of risky mortgage assets are also possible if the US housing market continues to decline.

Of course, there are other ways to value banks. Many analysts use price to book value or price to tangible book value, which excludes things like goodwill. But even on this measure the sector does not look cheap. Domestic UK banks trade on 1.3 times book value and 1.7 times tangible book value, according to Goldman Sachs.

“This compares to 1.0-1.2 in the early 1990s when goodwill was written off against reserves, so making it more comparable to price to tangible book vale today,” the broker says.

As with p/e ratios, it is worth questioning how useful book value is. After all, Northern Rock was nationalised at a fraction of its year-end book value.

Dividend yields are also misleading. On paper they look appealing, with the prospective yield for the domestic banking sector at about 8 per cent. But there is no guarantee expected payouts will not be reduced.

Graham Secker of Morgan Stanley says the banking sector is caught in a bear market rally, that has already run half its course.

He says investors should note the events of the early 1980s – the last time UK banks performed as badly as they have in the past year. After bottoming in November 1982, the sector outpaced the market by 18 per cent in the next four months, then underperformed for six years.

“We believe that the banks are going to struggle to generate any meaningful earnings growth over the next few years and, more likely, will suffer contraction” he says.

The credit crisis has done irreparable damage to the originate and distribute model which helped banks make record profits of late. Add to this the likelihood of a regulatory backlash and a slowing economy and it is difficult to be excited by the prospects for the domestic banks. Yes, the sector may have bottomed but sustained outperformance seems unlikely. If Mr Secker is right, any bear market rally is one worth selling into.