How to Play It: Going after banks post-stress tests

NEW YORK Thu Mar 15, 2012 9:55am EDT

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NEW YORK (Reuters) - In the carnage of the U.S. financial crisis, a familiar refrain echoed throughout Wall Street as the stock market tried to recover: "The market needs the banks for a healthy rally."

But since the 2008-2009 meltdown on Wall Street, stocks have done just fine even as bank shares remain far below their historic worth.

Still, the release of the Federal Reserve's annual stress test - first announced by JP Morgan Chase during Tuesday's trading - kicked off a strong rally that investors say could reestablish the banks as a leading sector after several years of following the market.

"The financials have been such a drag on the whole market for the last couple of years," said Larry Peruzzi, senior equity trader at Cabrera Capital Markets Inc in Boston.

"They're lending money, they're making money...it's the whole multiplier effect. Very few sectors you get that from, and that's what really drives the whole market."

When the credit crunch hit in 2008, banks plunged. The S&P 500 bottomed out at 12-year lows in March 2009 and the S&P financial index fell to just 8.9 percent of the overall S&P's market value, compared with a 20.1 percent weighting when the benchmark S&P hit an all-time high in October of 2007.

The idea is that since banks lend a multiple of the money they hold on hand, better financial health for those institutions helps markets. When banking and credit freezes, it's hard for the market to advance.

But the recovery rally since the 2008-2009 meltdown on Wall Street has proceeded even as banks saw ups and downs. The S&P 500 is at levels not seen since June 2008 and the Dow recently closed at its highest level since December 2007.

Tech is part of the reason: Technology stocks are worth more than at the market's heights in 2007. Banks, meanwhile, have only managed to recoup 30 percent of the massive losses incurred since the market peaked.

The banks now count for 14.5 percent of market capitalization, up from 8.9 percent at the 2009 low.

KEEP BUYING BANKS

Financials appear to have room for a sustained advance. The price-to-book ratio - which measures a company's stock price with the value of all of the company's assets - of the KBW Bank Index currently stands at 0.92 and 0.96 for the S&P financial index. For most of the last decade, the ratio for those indexes was over 2.

That level may not be reached anytime soon given ongoing concerns about exposure to Europe and increased regulation.

But the U.S. Federal Reserve's stress tests may bolster investor confidence for months to come. JPMorgan Chase & Co, generally considered one of the healthiest U.S. banks, currently holds a price-to-book ratio of 0.9.

"Financials are an integral part of, not only the health of our economy but the role they play in our indexes," said Ken Polcari, Managing Director, ICAP Equities in New York.

FOCUS ON THE REGIONALS

Regional financial companies may offer some of the more compelling values in the sector.

"I've liked (regional) banks for a while, and the stress tests provide another layer of confidence for investors in these stocks" by showing that the financial sector as a whole is stable, said Don Wordell, portfolio manager of the $2.2 billion RidgeWorth Mid-Cap Value Equity fund (SMVTX).

He holds large positions in Fifth Third Bancorp and Lazard. Fifth Third, in particular, has seen the performance of its mortgage portfolio in Michigan increase, noted Maclovio Pina, an analyst at Morningstar. The company trades at a price to earnings ratio of 12.2, making it slightly cheaper than the roughly 13 times earnings multiple of the broad S&P 500 index.

The industry may also be on the edge of a "wave of above-normal, small-bank consolidation," brought on by improving confidence in the financial sector and new regulatory requirements, said David Trone, an analyst at JMP Securities.

Trone estimates that some 400 institutions need to repay a total of nearly $8 billion in outstanding loans from the Troubled Asset Relief Program. That, he said, will likely lead to an additional $165 million in fees for KBW, a leading mergers and acquisitions firm.

For a broad bet on the regional banking sector, consider an exchange traded fund like the SPDR S&P Regional Banking ETF (KRE). The fund, which holds 50 regional banks with roughly equal weights, costs 35 cents per $100 invested and yields 1.6 percent. Popular Inc is its largest holding, with 2.2 percent of assets.

KEEP AN EYE ON TECH

Some argue financials are no longer the most important to markets, having been surpassed by technology because of its role in business expansion and operations. Bank of America-Merrill Lynch analysts said in a note to clients the sector is "the best way to gain broad exposure to secular growth."

Many have attributed the continued climb in technology stocks to the surge in Apple Inc, which has a 50-day correlation of 0.94 with the S&P 500. But tech has done well overall. For one thing, the sector is much less volatile when looking at earnings.

BofA-Merrill analysts note that tech earnings volatility has dipped substantially from the early part of the last decade. Earnings risk has increased in sectors that were considered staid, like financials.

If the bloom in the technology space continues, some analysts believe financials may not need to re-take their perch as leaders in order for stocks to move higher.

"They don't need to strap the other 85 percent of the market to their back, they just need to pull their weight, and that will be plenty fine," said Phil Orlando, chief equity market strategist at Federated Investors in New York.

(Reporting By Chuck Mikolajczak and David K. Randall; Editing by Andrew Hay)

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