FT Alphaville passes along an interesting report from Icap arguing that the tremendous rally in bank stocks has legs. This is the kind of argument that’s been a big moneymaker since late March, even as everyone has has been predicting the imminent end of the financial/junk rally (see: the latest report from Credit Suisse)
Globally, bank shares have doubled from their lows of early March. Investors now fret that with demand for borrowing poor, banks may struggle to generate substantial growth in their earnings per share. Predictably, with this level of bearishness, the bank sector in the US and in Europe is trading on a price to book of just around one, despite doubling in value.
Loss provisions & bank eps cycle
However, in the initial two years of the economic upswing it is not loan demand, but reduction in bad loss provisioning that drives bank eps . The sharp improvement in the newsflow on corporate profits, on aggressive cost-cutting and the levelling out of demand, has dramatically diminished default risk; junk credit spreads have fallen from around 20% to 8%. Unsurprisingly, bank share prices have doubled in six months, smartly outperforming the broader market.
Intriguingly, in each of the last three major cyclical recoveries, 1982-1983, 1991-1992, 2002-2003, the price-to-book of banks continued to increase along with bank eps and return on equity. Growth in book value and a return to a more normal price-to-book can only propel bank share prices higher over the next two years. The fact that equities are currently overbought and likely to consolidate presents opportunities. The story is not over for banks globally; use dips to increase exposure. Read the whole thing >
Shah also put together this clever chart, showing a correlation between tight credit spreads and bank performance (note the credit spreads number on the right is flipped, so that lower numbers appear higher on the axis). Assuming the direction remains steady — not a sure thing; spreads could widen again before “normalizing” — banks would likely rally.
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