Thursday, June 2, 2011

What To Do With Bank Stocks Now?

Financials were crushed yesterday.

The weak housing numbers, and growing evidence that the economy is slowing at least temporarily, is causing investors to move to other, more defensive sectors.

I have been generally cautious on the financial group. The debt that was created in the housing boom years of the last decade is unfortunately still lurking on bank balance sheets.

With house prices declining in most parts of the country, and real income growth a challenge for most American workers, it will probably take years before the housing market returns to normal.

I last tackled this question in January 2011 in Random Glenings. Here's an excerpt from what I wrote then, with the full link below:

Anemic loan growth; unrecognized loan losses; low interest rates; and possible "irrational exuberance" about future prospects - all should add up to a group that should be avoided.

And yet the financial sector has been on a tear over the last few months, boosting the returns of the S&P. Bank stocks in particular outperformed the market in December by 800 basis points. Woe to the equity manager that is either underweight or avoids the group.

So now my colleagues and I have to figure out what to do.

What we did, earlier this year, was add slightly to our financial weightings mostly through the use of the Financial Sector exchange-traded fund (XLF). This allowed us to get closer to our market benchmark (the S&P 500) but spread our risk among a basket of financial companies.

Now I am wondering if we should cut back again, but wondering if all of the "bad news" is already in the financial stock prices.

For example, CNBC had a piece which indicated that many hedge funds have been large sellers of bank stocks:

After making a killing buying the big banks at their nadir, savvy investors are moving on. Bank stocks are still cheap, but investors expect lackluster revenue growth and new regulations to keep prices depressed for some time.

"Financials have become hated in recent months," said Alan Villalon, a senior bank analyst at Chicago-based Nuveen Investments, which owns bank stocks

If you look at the bank stock universe in general, most are trading at a valuations that are about in the middle of the range of the last 5 years. This would seem to suggest that if one wanted to cut their financials position, it's not too late.

Valuations aside, it seems that the decision of whether to sell financial stocks or not is largely a market.

Ned Davis of Ned Davis Research (NDR) noted in a research piece a couple of weeks ago that financial stocks typcially begin to deteriorate 7-8 months, on average, prior to a stock market peak, based on the last ten NDR-defined bull markets since 1976.

Mr. Davis went on to say:

What bothers me about the Financials, beside their leading tendencies and connection to the debt bubble, is that all of this poor action has come after the massive stimulus by the Fed and the government to help this sector get bailed out from its own mistakes. Profits are up, and the Financials have been allowed to hide their toxic assets by not marking all their assets to real market prices, and the Fed has made the yield curve so wide that the banks are minting profits...Yet the banks are still underperforming.

Lots to think about this morning.