The reason why so many investors have been skeptical about the recent rally in stocks has to do with the role of bank stocks, which have been at the heart of both the drop as well as subsequent 20% rebound. The question is whether this recent dramatic move up in financials is sustainable or is merely a temporary blip, as the market reevaluates the inherent risks. I present a good summary by Goldman, arguing that all signs point to the latter. I particularly draw your attention to exhibit 9 showing the number and magnitude of some bear market rallies in the context of an overall declining market.
Rally in context
Bank stocks have staged a big rally and investors are now asking is this a bear market bounce or have we seen the bottom. In our view, this is a bear market bounce as:
(1) Non-performing assets are still accelerating: The fundamental data is not getting any better on consumer credit. Master trust data on credit cards points to a significant deterioration in consumer credit quality – losses increased 90 bps month on month which is the highest increase since the cycle started. Moreover, we are likely to see a resumption of writedowns in March given the “X” indices have fallen by 8% so far this month.
(2) Reason for rally: Part of the rally has been driven by comments from several banks that they have been profitable in the first 2 months of the year. However, we expect that some of this performance is driven by one-off factors such as write up on debt, mortgage origination fees, strong capital markets activity in Jan and Feb, which may fade in coming months and limited reserve builds despite our expectation that NPAs will continue to grow.
(3) Next catalyst: The next major catalyst in the banks sector will be stress test results, which will most probably come out in the middle of April. We cannot rule out banks unexpectedly failing this test and being forced to either raise capital from investors or take government capital. We expect that some banks that pass the test will look to issue equity to pay back government TARP. Either way, we expect significant equity issuance.
(4) Valuation may not provide a floor. We are now back to 0.8X tangible book, up from 0.5X two weeks ago. Both are low relative to long term averages. That said, when we look at prior severe regional home price depressions both in the US and globally, we find "trough" valuations within the range of 0.2X - 0.7X tangible book.
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