Friday, June 3, 2011

Bullish on Bank Stocks: A Contrarian View

Yesterday's note discussed my current dilemma regarding investments in bank stocks.

As you could probably tell, I am leaning towards reducing my positions in the financial sector, despite the fact that financials represent about 15% of the S&P 500.

As luck would have it, Jason Goldberg from Barclays was in town yesterday. Jason has followed large-cap and mid-cap banks for a number of years now, and is a first-rate analyst.

Unlike the consensus - including me, perhaps - Jason is a raging bull on the banking group, and believes that today's prices represent an opportunity for investors with a longer term time horizon to make some serious gains.

Jason acknowledged that he has never seen sentiment so negative towards his group. Everywhere he goes, he said, investors can list a number of reasons why they don't want to invest in bank stocks.

Although regulatory pressures could potential hurt the group (especially if banks are required to hold more capital), by far the most common concern is around tepid loan growth.

However, concerns about slow loan growth do not square with recent data.

For example, loan growth over the last few weeks has been ahead of the pace of the first quarter of 2011, according to the Federal Reserve.

As the brokerage firm Jeffries noted in a recent report, Commercial & Industrial loans increased +1.3% over the last 6 weeks. C&I growth was +0.7% in the first quarter of 2011.

Then there's valuation.

Jason noted that a couple of banks - Bank of American and Citigroup - are trading below tangible book value, and other banks are trading at the "cheaper" range of their historic valuation. At the same time, earnings reports for most banks have been actually pretty strong.

So what will it take for the bank stocks to start behaving better?

Jason went back to last year, when banks languished for most of 2010 and then rallied strongly into the close of the year. The bank stock surge at the end of the year was mostly the result of a sense that economic growth in 2011 might be better than anticipated, and that banks might actually show better earnings than Wall Street forecasts.

Now, however, the economy appears to be weakening again.

It is not clear whether this is a temporary phenomena (we had a similar economic pause in the early summer of 2010) or whether we are dangerously close to a more prolonged slowdown.

But I still conclude with the same observation as yesterday: if you think this is just a pause in economic activity, now is the time to be buying financials.

On the other hand, the more bearish view would of course lead you to the opposite conclusion.