There’s no doubt that we’ve seen an incredible five weeks for financial stocks. The S&P Financial Index has risen 80% since the lows of March. Other financial indexes have rallied even more. So investors naturally want to know whether this strength will last.
Let’s begin with some good news. For the year, the financials are still underperforming the broader S&P 500 index. The financials are still off by 16%, while the S&P is only down around 7%. So despite the tremendous rally, the stocks are still laggards, which might suggest there is some upside left.
What’s more, sentiment on bank stocks still seems negative, although not extremely so. Several of the big bank analysts are substantially less bearish than they’ve been in the past. Some, like Dick Bove, have turned absolutely bullish. But the overall bearishness could be a contrary indicator.
Thomas Brown at BankStocks.com is convinced the strength in financial stocks is likely to last. His argument for financials is long and multi-faceted, so we won’t attempt to parse through it all here. Read it for yourself.
But Brown issues a challenge we think we can meet toward the end of his latest bullish piece on financials:
I haven’t seen anyone among the bears make an argument, historical or otherwise, why financial services stocks ought to keep trading at their current, extreme valuations. (And when I say extreme, by the way, I mean extreme. To pick one number at random to illustrate the state of things, JPMorgan Chase lately trades at 90% of its book value.) For that matter, I’m having trouble finding where the bears discuss the stocks’ valuations at all. A lot of these folks have made some high-profile career moves lately. You’d think they’d be sweating the details. But show me a report by Meredith Whitney, or Mike Mayo, or Ed Najarian that contains a section that argues why it’s reasonable that XYZ banking company should continue to trade at less than book value once the crisis is past. The bearish analysts—not to mention the bearish contributors to SeekingAlpha–have totally lost any sense of context.
It is probably unfair of me to point out that Brown was writing that bank stocks had hit the bottom at “extremely depressed” valuations way back in July 2008. Back then he was a sceptic of the methodologies bearish analysts were using to value financial stocks, calling it poor analysis. He demanded that analysts prove that the stocks were over-valued according to old methodologies, refusing to take seriously the idea that the old techniques were failing to capture the risks that banks were taking.
Given that past resistance to new ideas, I doubt I’ll persuade Brown but I see no problem with JP Morgan Chase trading at 90% of its book value. You see, the concept of “book value” has been a terrible indicator of the value of financial stock returns. Given that we don’t have a clear way of valuing assets held by financials—much less the risks entailed by their business models—it’s not clear that “book value” is meaningful at all. Whatever book value’s association with equity value might be—the liquidation value or, say, the net stock of resources for future normal earnings—at a different kind of operating company, it may have almost no value for financial firms. I’m not even sure banks have something that can fairly be called a “book value.”
Because of the opacity of much of the sources of profits for financial firms, earnings ratios and the like may also be entirely irrelevant. For financial firms, it is the components of earnings rather than aggregate earnings that make the difference. And a lack of transparency, particularly at a large, complex financial firm like JP Morgan Chase, can obscure that information.
Cost efficiency also remains poor at financial firms. Goldman, for instance, is now paying its employees 50% of all revenues. That’s after cutting 7% of its workforce. As revenues have declined, banks have consistently argued that they need to keep pay high in order to keep talent. That is, cost efficiency is declining rather than improving. As we mentioned earlier today, this creates an unbalanced internal leverage situation that threatens to lower earnings if firms are forced—by, say, populist lawmakers—to delever by lowering pay.
Does this mean financials are at a top? Of course I’m not saying that. I also won’t try to tell you JP Morgan Chase should trade at 90% of book value rather than 110% or 70%. What I will tell you, however, is that many traditional measures of “fundamentals” are useless when it comes to evaluating equity values of financial firms.