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Bank Blues
Toronto: July 14, 2014
By John Stephenson

This time around it was a Portuguese bank, Banco Espirito Santo, Portugal’s largest listed bank by assets that sent global stocks on a downward path, reminding investors once again of the fragility of the European recovery.  Trading in the bank’s shares was suspended after a precipitous single-day fall of more than 17 percent, which at one point dragged the Lisbon stock exchange down more than four percent last week and pushed up yield on Portugal’s benchmark 10-year bonds by 21 basis points percent to 3.99%.  Trading in several Italian banks was also halted late last week as the FTSE MIB stock index in Milan fell as much as 2.9%, before paring its decline to 1.9%.

While stock markets stabilized by the end of the week, concerns about the recent dizzying run-up in stock markets and renewed uncertainty about Eurozone banks made for a turbulent week for global markets.  Anxiety over Europe was further heightened by weak industrial production figures out of Italy and France further underpinning the fear of a faltering recovery on the continent. 

This uncertainty comes just as the S&P 500 second quarter earnings season is about to really hit its stride, with 59 earnings reports scheduled for the upcoming week.  The backdrop to second quarter earnings is a market where the ratio of negative to positive guidance is running at 3:1—well above its historic average, sounding a cautionary note.  On tap for the week are many large cap banks, a sector that has trailed the S&P 500 year-to-date.  With earnings for the Financials expected to slump an estimated three percent year-over-year, the sector seems poised to continue as a headwind for the broader market. 

This week Citigroup Inc., JPMorgan Chase & Co. and Goldman Sachs Group Inc. are all set to announce earnings as investors have become increasingly disillusioned with U.S. banks.  The prospect of increasing regulation, lower leverage requirements and reduced trading activity have all weighed on investor sentiment, causing weakness in the sector and in the process creating the most under-weight segment of the U.S. market.

Trading, once a huge engine of growth for the Wall Street banks has come under pressure from reduced volatility and trading volume not to mention the Volcker rule.  Under the Volcker rule banks have been forced to jettison their trading desk that transacted for their own benefit.  In good times, these proprietary trading desks minted money for their respective banks. 

Fixed income trading is an area of particular weakness for Wall Street banks.  In the first quarter of this year, the world’s 10 largest investment banks experienced a 16 percent drop in their fixed-income trading revenue over the previous year.  Equity trading revenue was also lackluster and although revenue from stock offerings and merger and acquisitions increased, this was not enough to make up for the trading declines.

Loan growth has also deteriorated between 2012 and 2013 helping to foster investor angst toward the banks.  But more recently loan growth has been accelerating sharply over the past several months and that trend is likely to continue. 

Recent research from BMO Capital Markets U.S. highlights the relationship between the price-to-book ratio and the return on equity ratio (ROE) for the banking sector.  What BMO found was that price-to-book and ROE tended to move in lockstep, the higher the ROE the higher the price-to-book.  So much so that BMO’s work showed that changes in ROE account for roughly 76% of the changes in the price-to-book ratio.  And although the ROE for the sector is at depressed levels (10% consensus estimate for 2014) given the changing regulatory framework and weak trading environment, this would still imply that the current price-to-book was 23% undervalued across the banking group. 

With valuations depressed, market lagging performance year-to-date and negative investor sentiment, isn’t now the time to consider adding banks to your portfolio on a sector pullback?


I recently launched my own investment firm, Stephenson & Company Capital Management, which is focused on long/short fundamentally driven equity investing primarily in North America. I’m excited about being able to offer investors a vehicle in which absolute returns, risk management and capital preservation are paramount. You can find me on the web at  

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