Is This a Good Time to Invest in Banks?

| About: Financial Select (XLF)

A bank is a place that will lend you money if you can prove that you don't need it. ~Bob Hope

The old joke from Bob Hope in today's opening quote isn't quite as true as it used to be. For one thing, we're still recovering from a financial crisis that was sparked in large part by banks lending money to plenty of people without proof of, well, just about anything. For another, some think we're not really recovering at all due to the fact that a lot of those bad loans are still hidden in the depths of bank balance sheets ... or somewhere just far enough off the balance sheet to evade close scrutiny ... or on government/central bank balance sheets, which aren't looking too healthy either.

Financial Stock Performance

Still, financial stocks have led the markets higher since the March 2009 bottom, with many of them doubling or tripling from their crisis lows. Lately, however, bank stocks on both sides of the 42nd parallel seem to have hit an air pocket, underperforming the broader indices by a pretty decent margin. If you use the XLF as a proxy for U.S. financials, it was up an amazing 202% from the March 2009 lows to it's recent peak at the beginning of April. The broader S&P 500 was up about 106% over a similar time frame.

In Canada the difference is not quite as notable, probably due to the fact that Canadian banks fell less during the crisis. Using the Canadian ETF XFN as a proxy for the Canadian financial sector, you'll see a 137% gain from the lows in March of 2009 to the peak in April of 2011. As for the broader TSX Composite, I would have thought it fared better, given the run in commodity prices over the past year. Instead, we find that it was "only" up 92% over a comparable period of time.

If we take a look at the current market swoon, the XLF is (so far) down about 14% from April to June of this year, while the S&P 500 is only down about 6.7%. In Canada, the XFN is down about 6.1% from it's highs and the TSX is down about 8.1%. So Canadian financials, while lower, are still outperforming both the broader markets and their American peers. Financial Sector Headwinds I've been reading a lot lately about possible reasons for the recent selling of financial stocks, especially the big U.S. banks.

Here are a few of the recurring themes out there:

  • Slowing Economy: A spate of U.S. economic data that has significantly missed estimates (ISM, nonfarm payrolls, housing data) has some investors speculating that the economy is in a "soft patch" and that stocks and bank revenues will suffer as a result.
  • Increased Regulation: New regulatory regimes like the Durbin Amendment and Dodd-Frank Act may mean that bank revenues will take a hit in the near future. They could also affect their ability to borrow at the lower rates accorded to institutions with higher debt ratings. (See next point.)
  • Potential Debt Downgrades: Last week Moody's put the debt of Bank of America, Citi, and Wells Fargo under review for a possible downgrade due to the possibility that government support for these banks (and the toxic loans that are lingering with them) may no longer be there. The implicit government backstop, which became more explicit during the financial crisis, may be disappearing as political and public support for it is waning. This means banks may not be able to borrow as cheaply as they have in the past. (See next point again.)
  • Lower Net Interest Margins: Banks make a lot of money by borrowing at very low rates and lending at higher rates. The differential represents a significant revenue stream. If increasing regulation and debt downgrades become a reality, that stream may slow to a trickle due to a higher cost of capital.
  • Increased Litigation: Many big banks are also facing increasing costs due to legal problems. Headlines about mortgage servicing abuses at several U.S. financial institutions are not going away and rumblings of banks being held accountable for their part in the financial crisis continue from the U.S. Attorney General. Also, some investors are demanding put-backs from the banks. That means they want banks to buy back the toxic mortgage securities they sold during the subprime heyday.
  • Slowing Reserve Releases: At least some of the increased profits recently reported by the banks was attributable to the release of reserves. As the potential for more loan losses has subsided over the past year or so, banks have been able to release some of the reserves previously set aside for that purpose. Those reserves have helped their bottom lines, but can't continue to do so forever. Eventually, banks need to show real profits.
  • Hedge Fund Selling: Some large hedge funds that were early to invest in the big banks in the wake of the financial crisis have been paring back their positions in the second quarter. This has created some downward pressure on share prices.
  • Potential Commodities Correction: Apparently, a lot of big banks have cashed in on commodities this year as central bank policy has helped boost asset prices globally. If commodities correct sharply, as they are wont to, those profits could disappear or turn into losses. Some think the end of QE2 or the Chinese slowing their economy could be the catalysts that trigger such a correction.

It May Look Bad, But . . .

Looking at the list above, you might want to sell your financial stocks or ETFs. But many of these factors are still in the "what if" file. Some of them may not happen, and there are always some positive factors in that file too:

  • At least some of the economic slowdown could be attributable to the supply disruptions emanating from Japan, which are supposed to be "transitory."
  • The bark from regulators and litigators could prove to be much worse than their bite. They may once again be tamed by the powerful bank lobby, leaving many big institutions with nothing more than a slap on the wrist.
  • The U.S. housing market could finally touch bottom and begin to clear.
  • QE3 could ignite another rally in asset prices.
  • Hedge funds could then start to buy again.

And the virtuous - or vicious? - cycle begins again. Will Canadian Banks Rise above It All? Given the superior performance of the Canadian banks throughout the crisis, it's tempting to ask whether they're the better place to invest as financials pull back across the board. A recent article in the Globe and Mail postulated that the golden age for Canadian banks is over. In it, Rob Wessel warns against complacency by investors, financial professionals and journalists alike, citing the winding down of 3 main factors as reasons to curb your enthusiasm:

  1. Corporate tax rates have fallen over the past 20 years and probably won't fall much more.
  2. The favourable economic backdrop (low interest rates, low inflation, rising stock and bond markets) can't continue forever.
  3. Regulatory changes that allowed banks to become "financial conglomerates" have run their course. (Next is a shift from domestic to foreign expansion.)

While Wessel doesn't see outsized returns continuing, he doesn't think Canadian banks are a sell either. We just need to moderate our expectations a little. I would concur. While the Canadian banks will be subject to some of the effects of the global debt problems, they don't face the same type of balance sheet drag as their U.S. counterparts, partly because they don't have the same level of exposure to the U.S. housing market.

Further, the sovereign balance sheet here in Canada does not face the same debt ceiling-induced headline challenges as that of the United States. While it may be tempting for some to try to catch a few falling knives in the U.S. financial sector, I would prefer to pick up Canadian banks as valuations become more attractive.

Is now a good time to buy the banks? Would you prefer Canadian or U.S. banks - or both?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.