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While frothy may be a bit too hyperbolic, the excesses in some financial institution stock valuations begs the question of risk-adjusted returns expected by investors from this sector going into 2007 and through 2008.

We speak of stocks like Goldman Sachs (NYSE:GS), American Express (NYSE:AXP) and others sporting cyclically high p/e and price/book valuations. These names have provided substantial relative out performance over the broader financial institutions group, and their relevant sub-categories in recent quarters. One thing we do know is that most investors don't know much about how/where money is/will be made, as in the case of Goldman Sachs. For one, the earnings surprise factor for GS is off the charts and the highest among financials. For American Express the case is different, but the current valuation discounts unusually good things too far into the future [more on this in future dispatches].

If you strip out the added p/e or price/book premium [now firmly priced into the broader market] that investors have been convinced is merited based on the bond markets scorching rally from the high in yields, the potential alpha associated with incremental earnings, cash flow, and/or ROE [for GS and AXP for example] is quite modest. By my estimation, its less than100 basis points [for GS] and even less for other financials. The stories of the "story" stocks don't provide sufficient explanatory power for future incremental ROE [the only justification for improving realizable valuations] unless one takes the position of Bill Gross, and one puts a three handle on yields by early to mid 2007. Being rather agnostic on yields and more of the camp [lower rates are coming at the expense of a weaker dollar], those still trumpeting the "bull market"in financials are being somewhat disingenuous since a considerable portion of incremental money returns are are being erased in currency depreciation. Something has got to give.

Take Citigroup (NYSE:C). Just when everyone was bashing C for allowing Bank of America (NYSE:BAC) catch up [its market cap now exceed its own] and grossly under performing the whole universe, the stock proceeds to launch itself six points in two weeks. It appears that some institutional investors are gaming the bond trade, using the most sensitive [and liquid] FIG stocks as proxies for the long end [of bonds], a game that can end badly, for companies dependent on "unusually tight spreads" for financing growth.

Source: Risk Versus Reward In Financial Institution Stock Valuations