Better Times Ahead for Bank Stocks?

S&P, which has a neutral fundamental outlook on the industry, says earnings for diversified banks should begin to improve as charge-offs for bad loans subside

Perhaps a personal ad for the ideal investor in bank stocks these days would read something like this: "Wanted: Someone with the patience to weather frequent emotional outbursts but who is committed to reaping the rewards of a long-term association." Sometimes the greatest near-term challenges eventually become the greatest long-term successes. Can the same be said for bank stocks today?

The Standard & Poor's 1500 Diversified Banks subindustry index bottomed in mid-July 2008 after enduring a near two-year decline. Since then, the group has staged a price performance recovery, at least on a relative basis. Is the worst over, or is this group simply coming up for a last gasp of air? Year to date through Dec. 5, this subindustry declined 31.8% vs. a 40.3% decline for the S&P 1500 (the combined S&P 500, S&P MidCap 400 and S&P SmallCap 600 indexes).

Take a look at the accompanying chart. As a reminder, the jagged blue line represents the subindustry index's rolling 52-week price performance as compared with the 52-week performance for the S&P 1500. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the index's long-term mean relative strength.


There are four large-cap stocks in the S&P 1500 Diversified Banks subindustry index: Comerica (CMA), U.S. Bancorp (USB), Wachovia (WB), and Wells Fargo (WFC). (Wells Fargo is scheduled to complete its acquisition of Wachovia by the end of 2008.) Stuart Plesser, the equity analyst who follows this group for S&P, has a neutral fundamental outlook for the diversified banks subindustry, reflecting the benefit of recently approved capital injections directly into a myriad of banks and a recent reduction of the Fed funds rate, offset by the likelihood of slowing economic growth and higher charge-off rates for soured loans.

In S&P's view, credit quality is deteriorating, particularly for construction and credit-card loans, and the deterioration is starting to spill over to commercial loans. S&P believes that rising unemployment levels and steadily falling home prices will lead to higher charge-offs in 2008 and 2009. That said, the government's injection of capital into banks may stave off the need for additional capital raises and will likely lead to consolidation in the banking space as weaker players are bought out, according to Plesser.

Although loan modification programs may curtail charge-offs, instituting a broad-reaching plan may prove difficult. Commercial loan growth and charge-offs have remained solid through the third quarter but Plesser believes credit will deteriorate in this loan category as well. Positively, net interest margins will likely improve from third-quarter levels due to recent rate cuts. S&P expects tighter lending procedures to slow origination growth. In Plesser's view, operating expenses are well controlled in general for companies in the group, and further headcount reductions should result in lower expenses in the quarters ahead.

S&P believes a bank's exclusion from access to government funding is a sign of weakness, and that those banks will likely need to merge with stronger players. Although S&P believes capital is king, due to government intervention, the playing field has somewhat been leveled and those banks with excess capital will likely not be able to grow market share as much as they previously could have without the government intervening.

For the longer term, Plesser's outlook is more favorable, as large diversified banks with solid capital levels have been able to gain market share from weaker competitors. Once charge-offs begin to subside, he believes the earnings power of these banks should rise significantly vs. pre-credit-crisis levels. Plesser continues to favor banks with diversified revenue mixes, by product set and geography, as S&P believes they should have an easier time posting EPS growth in a varying range of economic environments.

So, there you have it. The improving relative strength of the Diversified Banks group is confirmed by a neutral fundamental outlook, in S&P's view. Of the stocks mentioned above, Wells Fargo and Comerica are ranked 4 STARS (buy), while U.S. Bancorp and Wachovia are ranked 3 STARS (hold).

Industry Momentum List Update

Here is this week's list of the subindustries in the S&P 1500 with Relative Strength Rankings of "5" (price changes in the past 12 months that were in the top 10% of the S&P 1500), along with an index component with the highest S&P STARS (tie goes to the issue with the largest market value).

Subindustry Company Ticker S&P STARS Rank Price (12/5/08)
Air Freight & Logistics FedEx Corp. FDX 4 $74
Biotechnology Genzyme Corp. GENZ 5 $66
Brewers Molson Coors TAP 4 $41
Education Services DeVry Inc. DV 4 $58
Environmental & Facilities Services Waste Management WMI 4 $30
Health-Care Services Laboratory Corp. LH 4 $64
Home Improvement Retail Lowe's Cos. LOW 4 $22
Household Products Procter & Gamble PG 5 $63
HyperMarkets & Super Centers Wal-Mart Stores WMT 5 $58
Insurance Brokers Aon Corp. AOC 4 $44
Packaged Foods & Meats J.M. Smucker SJM 5 $42
Railroads Norfolk Southern NSC 4 $46
Restaurants McDonald's Corp. MCD 5 $63
Water Utilities Aqua America WTR 3 $20

Source: Standard & Poor's Equity Research

Business Exchange related topics:Bank NationalizationMarket BottomU.S. Stock Market

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