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A Moody's sign at the 7 World Trade Center tower in New York. (MIKE SEGAR/REUTERS)
A Moody's sign at the 7 World Trade Center tower in New York. (MIKE SEGAR/REUTERS)

Moody's comes late to U.S. bank turnaround Add to ...

The U.S. banking system is safe again, at least according to Moody’s Investors Service. Should investors be nervous?

The credit rating agency raised its outlook on the sector to “stable” on Tuesday, removing the “negative” label that had been applied to it since 2008, when the financial crisis claimed the lives of Bear Stearns and Lehman Brothers.

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But while the Moody’s upgrade is welcome, it comes far behind the vote of confidence that investors have already given the sector. U.S. bank stocks have risen 18 per cent over the past year and they are up more than 230 per cent from their lows in 2009.

Indeed, you have to wonder if the upgrade – at least from a share price perspective – serves as a reason to turn cautious on banks after their extraordinary rally.

According to Moody’s, the upgrade reflects an improvement to the banks’ operating environment and their greater resilience to an economic downturn.

The credit rater hardly sees the U.S. economy storming ahead. It projects sluggish economic growth ranging between 1.5 and 2.5 per cent between now and 2014. Unemployment should retreat to about 7 per cent, still high but continuing a trend that has seen the rate slide to 7.7 per cent in April.

Interest rates – “the single most important factor driving U.S. banks’ performance in the next 12 to 18 months,” according to Moody’s – should remain low, supporting employment growth and real estate values.

“As a result, banks’ asset quality metrics continue to improve, with net charge-offs now approaching pre-crisis levels,” Moody’s said in its report.

In an interview, the authors of the report said they don’t see a further upgrade of the sector to “positive” any time within the next 12 months, but it is possible after that time should the banks continue to improve their balance sheets and individual banks receive more credit rating upgrades of their own.

Among the 60 banks rated by Moody’s, just one has a “positive” ratings outlook right now: Susquehanna Bancshares Inc.

The question for investors is whether the Moody’s upgrade now suggests bigger gains ahead for bank stocks, as the market grows confident that the rally over the past four years is based on something more concrete than a vague belief that things aren’t getting any worse.

Sean Jones, associate managing director at Moody’s, pointed out that prices of bank stocks relative to their book values are still low.

Many stocks in the sector traded below their book values for a long time following the financial crisis and the average price-to-book ratio for the 24 stocks in the KBW bank index is now just 1. U.S. bank stocks traded at about twice their book values as recently as 2006, which is about where their Canadian counterparts currently sit.

This low valuation is why many observers – including strategists at Bank of America – believe that U.S. bank stocks are compelling investments today. With share prices still nearly 50 per cent below their highs before the financial crisis, there seems to be ample room for further gains.

But the more that investors pile into this trade, the less likely that advances are going to continue to dazzle.

Now, with Moody’s voicing its approval and with credit rating agencies in general tending to act as lagging indicators, you have to wonder if much of the good news has already been priced into bank stocks.

The upside is still there, but rising bullishness means that investors should keep a close eye on the downside too.

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