Are Bank Bulls Mistaken?

Brittney Barrett |

Bank of America BACInvest in a bank during 2011? Sorry to hear it. Major banks took a terrible beating in 2011, with many of the major players having to cut thousands of jobs to minimize losses at year end. Considering the downward trajectory the big banks experienced during 2011, and the ongoing influence of many of the factors that led to it, it's surprising that Barclays analyst Jason Goldberg would take such a bullish position for his 2012 bank outlook, which stated, “At current valuations, we believe the risk of not owning U.S. bank stocks is greater than owning them."

Goldberg's attitude is not uncommon even if it sometimes seems unsupported. Bullishness toward banks was embraced by innumerable investors, who dove into the bargain bins to snap up bank stocks when they were 50 percent off highs, only to watch them plunge even lower again. The traditional metrics of what “cheap” really means for a bank stock have been turned upside down and while it's difficult to argue with single digit prices for some of the largest companies in the world, it’s equally as challenging to devote a significant portion of a portfolio to them.

Unlike the past, when economists and the Federal Reserve may have been able to predict the direction of banks and the broader economy, fresh headwinds and variables have been changing the game.  Just as in 2011 when ongoing litigation and payouts forced banks to give up some of their profits, 2012 has a number of potential challenges that analysts could be overlooking.

Bloomberg says that analysts far overshot the strength of big banks last year, anticipating a 32 percent increase, when in fact, they experienced profit losses of around 18 percent. This year, analysts are supposing the five major banks, Citigroup (C), Bank of America (BAC), Morgan Stanley (MS) and Goldman Sachs (GS) will expand their earnings by 57 percent. Considering how off base they were last year, and the difficultly of measuring the impact of the European sovereign debt crisis and the appearance of lawsuits, it can be a challenge to take these numbers seriously.

So why would anyone want to take a bullish position right now? Among the reasons is the fact that banks have been cutting costs, dramatically, and will continue to do so through 2011. While ordinarily cost cutting is a good thing and routinely sends shares higher following the announcements, it’s not without its impacts. Fewer employees could change other dynamic at these banks and reduce revenue alongside cutting costs, making the net outcome less impressive than expected.

Beyond the cost reduction measures, analysts also cited an increase in investment banking deals for the coming year. 2011 was a soft year in investment banking in spite of low fees, and with the global economy slowing, the evidence that this will change seems tenuous. There’s the added factor of capital depletion from the previous year, which will mean less cash will presumably be free in order to perform such deals.

The reality is that both the cost cutting and the increased investment banking could contribute to a stronger year for banks, but it would rely heavily on the global economy.  Bank of America and Citigroup, two of the banks bargain bin enthusiasts tend to pursue most aggressively in times of trouble are those most vulnerable to the European debt crisis.  All together the top five banks have around $22 million hedged in the crisis, or did at the end of 2011.

Those with the least exposure and the greatest track record for functioning effectively in a weak economy are Morgan Stanley and Goldman Sachs. According to Barron’s there remain trading and banking opportunities, which tend to be central to the success of these two banks. Goldman especially has a history of success in navigating through tough times with hard trades. Still, in Q3 of 2011 the bank did not manage to turn a profit, marring its track record and making some wonder how it will effectively change this trajectory with nearly identical global headwinds.

 

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
BAC Bank of America Corporation 15.16 -0.22 -1.43 78,613,499
C Citigroup Inc. 45.80 -1.07 -2.28 28,056,905
GS The Goldman Sachs Group Inc. 158.95 -4.50 -2.75 3,731,220
MS Morgan Stanley 31.04 -0.73 -2.30 12,453,651

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