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Published: July 12, 2010
"I don't see the earnings power in banks."
That's what banking analyst Meredith Whitney said in a Bloomberg
interview on May 5.
Last year, banks reported huge profits due to favorable changes
in government policies. For example, the government purchased
agency paper from banks. This helped ease funding pressures.
Then, banks no longer had to assign a current market price for a
security ("mark to market") on its books. Instead, they could
use "significant judgment" when valuing their illiquid
investments.
These one-time events will no longer boost profits for the
sector. That's why Whitney is predicting a steep decline in
earnings.
Whitney is one of the best banking analysts in the industry. And
she deserves credit. Since her call, banks have taken a steep
dive.
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Whitney is even more
cautious today. On
July 9, she cut her
second-quarter
earnings estimates
on investment banks
Goldman Sachs
(NYSE: GS) and
Morgan Stanley
(NYSE: MS) by
64% and 41%,
respectively. She
said the last three
months "was the
worst quarter for
debt and equity
underwriting volume
in over a year."
She's not the only
one cutting earnings
estimates.
Analysts at Sandler O'Neill, Sanford
Bernstein, Credit Suisse, and Deutsche Bank have also cut
second-quarter earnings estimates for most large-cap financials.
In fact, I can't find an analyst in the sector who raised
earnings heading into the quarter.
This makes sense given the uncertainty behind the financial
reform bill, which is sure to eat into profits. But the last
time I've seen such low expectations on this sector was back in
March 2009. And the Financial Select Sector Fund (NYSE: XLF)
jumped 100% in 12 months.
Now, I'm not predicting another 100% rally from these levels.
But I think the sector is a buy here.
Along with low expectations, several
catalysts could push financial stocks higher. For one, interest
rates will remain low at least another 12 months. This helps
profits. Banks can borrow money cheaply and make loans at much
higher rates.
Also, I expect a major uptick in mergers and acquisitions (M&A)
over the next six to 12 months. S&P 500 companies are starving
for growth. They have tons of cash on their balance sheets.
Plus, many companies are down more than 40% since May. That's
the perfect recipe for M&A -- which generates profits for banks
who act as middlemen.
Mortgage rates continue to hit new record lows. In April, the
30-year fixed mortgage rate was over 5%. Today it's 4.69%, the
lowest level since 1971. Most industry pundits expect this rate
to fall farther. Not only could low rates boost new home
purchases, but banks should see a huge increase in refinancing
activity.
Finally, banks are at attractive valuations. Bank of America
(NYSE: BAC), Citigroup (NYSE: C), and JP Morgan
(NYSE: JPM) are down about -25% since May. They now trade
below book value. Goldman is trading right at its book value. It
doesn't mean bank stocks can't go lower. But it does imply that
risk is limited.
Earnings season for banks starts on Thursday, July 15. That's
when JP Morgan reports. Based on the massive pullback in the
sector coupled with extreme low expectations, I'd be a buyer
here.
-- Frank Curizo
Editor
Penny Stock Specialist |
