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As U.S. banks recover, stocks should follow suit Add to ...

Fabrice Taylor, Chartered Financial Analyst, is a principal in Capital Ideas Research and writes the blog fabricetaylor.com

Rob Wessel spent a recent Sunday screening U.S. bank stocks for bargains, notably names with abundant capital and quality assets. The veteran analyst has seen a lot in his day but he was pleasantly surprised by what he found: "Banks I'd never heard of trading for less than book value."

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You can draw a couple of conclusions from this: Mr. Wessel could use a hobby, and we may be on the verge of a roaring bull market in U.S. bank shares.

That is certainly his view, and one of the reasons he started Hamilton Capital Partners after a stellar career as the man on banks at National Bank Financial. During his tenure there, he was a top-ranked analyst every year and later a proprietary trader specializing in financials. The long-short fund he managed with colleague Jennifer Mersereau returned 24 per cent over a 22-month span that coincided with the worst of the credit crisis.

We therefore assign a high degree of confidence to his ideas. And his current big idea is fairly simple and persuasive: After stunning loan losses, U.S. bank earnings are poised to recover sharply. The stocks should follow.

As exhibit A, consider what happened to bank shares after the last banking debacle south of the border, the savings and loan crisis. In the five years after the S&P Banks Index hit rock bottom, it rose almost 300 per cent. Mr. Wessel believes that if bank earnings haven't hit bottom yet, they will imminently.

But this is no ordinary trough. This credit cycle is notable for how deep and how long it has been. Hard as it is to believe, we are in the eleventh quarter of the current cycle - that's almost three years. Net charge-offs have been higher than they've been in 75 years - easily so. The price-to-book multiple of the S&P 500 Banks Index has fallen to about a third of its peak of 3.7 times and is, Mr. Wessel asserts, poised to rise.

What turns bank results around? GDP growth is an obvious indicator. The end of a recession is typically accompanied by declining losses. The economy does appear to be turning around, notwithstanding bold predictions from the bearish crowd of a double-dip recession (most recessions are, anyway).

Improving unemployment tends, naturally, to correlate with improving consumer credit, meaning borrowers can cover their mortgage and car payments. Job losses are moderating.

Finally, credit spreads presage lower losses. Although corporate credit spreads remain quite high, they are falling.

At a micro level, the indications are improving as well. Looking at all U.S. domiciled exchange-traded banks and thrifts, Mr. Wessel finds that balance sheets are remarkably healthy on average, especially given the severity of the recession. Reserves are strong compared to loans, core deposits are up and charge-offs seem to have peaked. Having in some cases been forced to raise money, the bank's have very good capital ratios. Not all indicators are positive, but the trend appears to be on the mend.

Once profits return, book values start to rise, and combined with rising price-to-book multiples, that makes for a double-barrelled opportunity on the long side as both factors drive stock prices higher.

That's not to say every bank is a buy. More than a few will fail, and Mr. Wessel, whose funds will also sell stocks short, will be able to profit from those failures if he identifies them.

The U.S. banking system is different than ours, which is dominated by the big banks, whose performances are highly correlated. There are more than 500 financial stocks in the United States whose performances vary. Quality research can add value.

Is all of this priced into stocks? I doubt it. The U.S. banking system is different than ours, which is dominated by the big banks, whose performances are highly correlated. There are more than 500 financial stocks in the United States and their performances vary.

And the market tends to assume a trend will continue until it finds powerful evidence to the contrary, which helps explain how bank shares plunged so suddenly when the cycle turned, even though there were plenty of signs of trouble to come. The same can happen on the other side, too, making for excellent potential returns, especially given the severity of this downturn. Quality research can add value.

As Mr. Wessel says, "I think we're at a historic moment."

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