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Watching U.S. Banks

(October 20, 2011)

Dear Subscribers and Readers,

Unless one has been in a cave lately, there's been no escaping the carnage in banks—whether it's the “Occupy Wall Street” movement, the forced bank recapitalizations in Europe, Goldman Sachs losing money, and worst of all, the ongoing decline in U.S. bank stocks.  For example, the XLF (Financials Select Sector SPDR) is trading near its mid-2009 levels; and on a relative strength basis (versus the S&P 500—see bottom panel of the following chart, courtesy of Decisionpoint.com), XLF is trading at its early 2009 levels:

My personal opinion is that the latest decline is due to fears of an uncontrolled European Sovereign Debt Crisis, uncertain regulatory environment, and perhaps another U.S. recession.  With investors having been burned by financials just a few years ago, it is understandable for them to be experiencing a “once bitten, twice shy” syndrome.  Unlike dating, however, such a sentiment usually provide a good investing opportunity, especially since U.S. banks are in the aggregate making money (i.e. building tangible equity)!  Not surprisingly, U.S. bank valuations (on both a pre-provision-operating profit and tangible book basis) are now at their lowest levels since early 2009 (following chart courtesy of Goldman Sachs).

What is surprising is that book valuations have been shrinking despite a continuing growth in book value (i.e. banks are still making money)!  This is contrary to historical experience, as shown in the following chart (again courtesy of Goldman Sachs).

We believe that the sell-off in banks is due to an unwarranted fear—perhaps to another U.S. recession, but most likely, fear of an uncontrolled debt spiral in Europe, along with a bad memory of being burned by bank stocks in 2008/early 2009.  Even if the U.S. enters a recession (which we do not anticipate), the build-up in tangible equity is sufficiently high to avoid a mass recapitalization or a systemic crisis.  More important, loans and leases under U.S. commercial bank credit are actually growing this year (see below chart).  Year-over-year change in loans and leases is up 1.0%; and up $103 billion (to $6.86 trillion) on a YTD basis.  Given the banks' newfound conservative lending standards, this growth in lending should lead to higher profits and higher GDP growth later this year and 2012.  We believe U.S. financials will be a buy at some point before the year ends.

Signing off,

Henry To, CFA, CAIA

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