Lehman Haunts Banks Even After Shares TripleWhitney Kisling
For all the efforts to regulate banks since Lehman Brothers Holdings Inc. collapsed, stock investors have no more faith in U.S. financial institutions now than they did in early 2008, relative to the rest of the market.
While the Standard & Poor’s 500 Index trades at a level that’s 16.2 times reported operating earnings, up 11 percent from this time last year, banks, brokers and insurers are at 13.2 times profits, the cheapest among 10 American industries, according to data on average valuations this month compiled by Bloomberg. Even after financial shares tripled in the four-year bull market, the gap between their valuations and the S&P 500 is as wide as in early 2008.
Tighter regulation and reduced risks have failed to restore confidence that bank profits will be worth paying more for, even as analysts project earnings at financial firms will expand three times more than the S&P 500 this year. Bulls say low valuations mean there’s room for financial shares to beat the benchmark equity index as the economy accelerates. Bears say new rules will prevent American banks from returning to their record share-price highs.
“The crisis is certainly something that still troubles investors,” John Carey, a fund manager at Boston-based Pioneer Investment Management Inc., which manages about $200 billion, said in a Sept. 10 phone interview. “It’s 2013 and we’re talking about things that happened in the middle of the 2000s. As investors, we’re still a bit concerned about the fallout from all of that, which hasn’t been completely put to rest.”
Analysts say earnings at banks will increase 15 percent, compared to 3.2 percent for the rest of the market, according to more than 11,000 estimates compiled by Bloomberg. While the index surpassed its pre-crisis record this year, financial shares remain 47 percent below the high in February 2007, more than any other industry.
Shares of telecommunication and consumer discretionary companies are the most expensive in the S&P 500, trading at more than 21 times reported earnings last week. Consumer stocks have rallied the most since their pre-crisis highs, rising at least 36 percent above those records, according to data compiled by Bloomberg.
The S&P 500 rose 2 percent to 1,687.99 last week as China’s economy showed signs of improvement and mergers increased optimism in the U.S. Goldman Sachs Group Inc. rallied 4.7 percent, helping financial shares gain 1.9 percent, after S&P Dow Jones said the fifth-biggest U.S. bank by assets will be added to the Dow Jones Industrial Average.
The S&P 500 climbed 0.6 percent at 4 p.m. New York time after Lawrence Summers withdrew from the race to be the next Federal Reserve chairman.
The 81 banks, brokerages and insurers in the S&P 500 have gained 23 percent in 2013, 4 percentage points more than the full index, after rising 26 percent last year. Genworth Financial Inc., the Richmond, Virginia-based life insurer, has climbed 63 percent while its price-earnings ratio expanded 1.4 percent this year. Charlotte, North Carolina-based Bank of America Corp.’s shares rallied 25 percent this year on a 2.2 percent valuation increase, data compiled by Bloomberg show.
Financial firms have almost tripled their earnings in the three years since 2009, rebounding from the first annual net loss since at least 1990 and almost matching the 224 percent rise in the shares.
The lock-step growth held valuations steady over the last 12 months even as the price-earnings ratio for the S&P 500 widened by 11 percent, according to data compiled by Bloomberg.
Sentiment toward bank stocks failed to improve after chief executive officers were forced to rebuild reserves in 2010 and contend with Europe’s sovereign debt crisis a year later. While the shares are up 24 percent the last 12 months thanks to earnings gains, valuations are unchanged as the U.S. Fed prepares to curtail bond purchases at the same time that new regulations require the companies reduce some of their most profitable, and most risky, businesses.
“It is an unstable industry for anyone looking for a steady income stream,” Andrew Hadley-Grave, investment managers at Fleming Family & Partners Ltd. in London, which oversees $6 billion, said in an interview on Sept. 12. “Our strategy is such that we don’t need to own them if we don’t like them, so we are staying away,” he said. “You can outperform the market without owning financials.”
Bank stocks bore the brunt of the credit crisis, with the S&P 500 Financials Index plunging 83 percent between October 2007 and March 2009, almost 1 1/2 times the full gauge. The drop included declines of 23 percent in October 2008 and 27 percent in January 2009, data compiled by Bloomberg show.
The 10.6 percent plunge on Sept. 15, 2008, was the biggest one-day calamity in the financial index’s history. It was eclipsed by a 16.1 percent retreat on Sept. 29, in a month when Lehman Brothers collapsed, Merrill Lynch & Co. and Wachovia Corp. were rescued by sales, American International Group Inc., Fannie Mae and Freddie Mac were bailed out by the government and Washington Mutual Inc. declared bankruptcy.
Almost $11 trillion of U.S. equity value was erased from peak to trough, including more than $2.4 trillion from banks.
Policy makers have spent the last five years setting rules to rein in risk-taking and reduce financial leverage. The 2010 Dodd-Frank Act, the biggest overhaul of market regulation since the Great Depression, and other rules require banks to curb trading for their own accounts, double capital for the biggest firms and use clearinghouses for derivatives trades.
Even with tighter controls, faster earnings growth and a pickup in the economy may boost financial shares more than the rest of the market, according to Todd Wittgenstein, a Los Angeles-based fund manager at HighMark Capital Management Inc., which oversees about $19 billion. The enactment of regulation after years of negotiations will spur CEOs to deploy excess capital back to shareholders, he said.
“Right now they’re being priced as if it’s still Armageddon,” Wittgenstein said Sept. 12. “Financial services are like a coiled spring.”
Initial jobless claims reached the lowest level in seven years this month, manufacturing reached a two-year high and a report showed gross domestic product expanded faster in the second quarter. The U.S. economy will grow 2.7 percent next year and 3 percent in 2015, the most since 2005, according to the median of 81 forecasts compiled by Bloomberg.
The average ratio of tangible assets to tangible equity, a measure of leverage, is down to 12.8 for the six biggest American banks as of June 30, according to data compiled by Bloomberg. That compares with 27.5 at the end of 2007.
That hasn’t translated into higher valuations.
Morgan Stanley has doubled equity and customer deposits to cut reliance on short-term borrowing, which accounted for more than half of its funding in 2008. The sixth-largest U.S. bank’s assets are 14 times its equity, as of the end of June, compared to 38 at the end of 2007. Shares of the New York-based company trade at 15.2 times reported profit, down from 24 times in 2008.
Goldman Sachs, based in New York, doubled earnings last quarter, beating analyst estimates for the seventh straight time, data compiled by Bloomberg show. The price-earnings ratio of 9.7 compares with 8.7 five years ago, even as Chief Financial Officer Harvey Schwartz said the firm is “very comfortable” with its ability to meet a proposed U.S. minimum ratio of capital to assets.
Sheila Bair, former chairwoman of the Federal Deposit Insurance Corp., has said financial institutions must do more to pare their debt.
“Large financial institutions still have way too much leverage,” said Bair, who now leads the Systemic Risk Council, a nonpartisan group whose members include former Federal Reserve Chairman Paul Volcker and former Treasury Secretary Paul O’Neill, in a Sept. 11 interview with Bloomberg Television. “We have gotten more capital into these banks as a result of these stress tests, but we were starting from a very low base.”
While record-low interest rates have encouraged lending, they’ve reduced profits. Net interest margin, the difference between what lenders pay for deposits and charge for loans, was 3.06 percent last quarter, near the lowest on record, according to Federal Reserve data on U.S. banks with more than $15 billion in assets. The measure has fallen for 12 of the last 13 quarters.
The central bank has said it won’t raise its target for the Fed funds rate until U.S. unemployment, now at 7.3 percent, falls to 6.5 percent, as long as projected inflation doesn’t rise above 2.5 percent. Fed funds futures show a 63.3 percent probability that interest rates will stay between zero and 0.25 percent 12 months from now.
Even with the highest projected per-share earnings growth among 10 industries, S&P 500 financial firms’ total net income is forecast to reach $183 billion this year, 20 percent below the total in 2006, data compiled by Bloomberg show.
“It is a different environment that they are operating in today versus then and likely this is what they will continue to operate in,” Walter Todd, who oversees about $950 million as chief investment officer of Greenwood Capital Associates LLC in Greenwood, South Carolina, said by phone Sept. 12. “By definition, returns on equity are going to be lower, and valuations won’t necessarily get back to those levels.”
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