MorningWord 2/1/16: Crying All the Way to the Bank

by Dan February 1, 2016 9:13 am • Commentary

This weekend, Barron’s was fairly emphatic that it is Time to Buy Bank Stocks:


Their bull case is largely predicated on valuation:

the 10 leading banks and investment banks now trade for eight to 12 times projected 2016 earnings—a steep discount to the market multiple of about 16—and many trade near or below tangible book value. Some sport yields of 3% or more, and all will probably get the regulatory go-ahead to lift dividends later this year.

There’s probably at least 20% upside in all of these banks, which would still leave some below where they started the year

The article also makes the case that fears of some sort of credit event from energy related defaults may be overblown:

Wall Street is worried about the industry’s loans to the increasingly distressed U.S. energy sector. But based on information provided on banks’ energy exposure in fourth-quarter earnings releases and presentations on conference calls, that exposure looks manageable. Oil-and-gas companies generally account for no more than 1% to 3% of total loans, and banks already have set aside reserves against potential losses.

And sentiment got really bad, really quick in 2016. Until Friday’s rip, the sector looked like it was sitting out the prior week’s bounce from the lows with most stocks in the group down at least 20% from their 52 week highs, with some like Citigroup (C), Goldman Sachs (GS) and Morgan Stanley (MS) down more than 30%.

On Jan 19th I took a look at the poor performance of the sector year to date Bank Stocks – The Meh, the Bad and the Ugly, pointing out that U.S. bank stocks actually acted the best among peers in Europe and Asia, but for the most part were downright horrible, and may be speaking to broader weakness to come across the U.S. stock market.

I suspect what the author is most focused on the money-center banks, but this comment regarding the top two investment banks MS and GS stuck out like a sore thumb:

IT’S RARE TO FIND both Goldman Sachs and Morgan Stanley trading below tangible book value. Current returns aren’t great, with Goldman Sachs earning an 11% return on equity and Morgan Stanley, 8%. Yet, at nine times projected earnings, both discount much weaker outlooks.

Before buying these stocks blindly, I think it makes sense to take a look back at the last few times U.S. banks stocks have had sell offs of at least 20% from their highs. The results are a tad divergent between investment and money-center banks. Because MS has been the hardest hit of the majors, let’s look there first.

MS has had four peak to trough declines of at least 60% in the last 20 years. The first was a decline of 62% in 1998 with the demise of hedge fund firm Long Term Capital Management. Second, from its highs in 2000 to its lows in 2002 the stock lost 73% in the aftermath of the dotcom crash and the ensuing bear market. Third, from its highs in 2007 to its lows in 2009 during the financial crisis, when the company nearly went out of business, the stock lost 90% of its value. And finally, 62% from its 2011 highs to its lows during the European Sovereign Debt Crisis in 2011.  Since its highs late last year, MS has now declined about 35%, but it is still up 100% from its 2012 lows.

MS 20 year chart from Bloomberg
MS 20 year chart from Bloomberg

So what gives? Cheap valuation, low leverage ratios, limited exposure to energy may all be a thing, but in the current regulatory environment, low leverage means challenged profits. Bear markets mean less deal activity (there was not a single IPO in January 2016 vs 20 in January 2016), volatile stock market means cautious investors in their massive wealth management division, and trying to pinpoint energy exposure before we have seen a large default may be like suggesting in 2007 that exposure to subprime mortgages is contained.

GS lost 55% of its value from its 2000 highs to its 2002 lows, 80% during the financial crisis, 50% during the Euro Sovereign Debt crisis  and is down now about 26% from last year’s highs, but up 90% from its 2011 lows.  For similar reasons to MS.

GS 17 year chart from Bloomberg
GS 17 year chart from Bloomberg

And the grand-daddy of them all, JPM (slightly different reasons than the investment banks, which can help or hurt depending upon the issue for the crisis), lost 54% following Long Term Capital’s collapse, lost 72% in post dotcom implosion, lost 72% from its 2007 highs during the financial crisis, 42% during Euro Sovereign Debt Crisis and now is down 16% from its 52 week high, it was down 22% two weeks ago.  JPM is showing very healthy relative strength to Bank Of America (BAC) and Citigroup (C) which are down 22% and 30% respectively from their 52 week highs, but I think its safe to say given the latter two banks most recent history, investors will crowd in JPM in uncertain times for those who need to be exposed to the space.

JPM 20 year chart from Bloomberg
JPM 20 year chart from Bloomberg

The main take-away for me is quite simple, to dismiss the unknown when it appears that the price action is telling you something that valuation, fundamentals, and the financial press are not is a bit silly.  I would add one last point, there are no shortage of 10-20% declines over the last 20 years of the charts above, which seems about right for an economically sensitive sector like the banks, but if you get it wrong on the long side in this group when its in the midst of a once every 5 to 7 year 50% plus decline, you don’t want to be making a bullish argument on tangible book value alone down 25% from the prior high.