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U.S. financial sector holds key to recovery Add to ...

Euro-zone bank contagion fears, tougher capital rules and looming restrictions on trading and derivatives continue to cloud the outlook for U.S. financials.

With healthy banks widely seen as essential to economic recovery, there is concern that U.S. equities will struggle in 2012 unless financials break out of their deep slump.

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On the plus side, however, some investors are taking a close look at cheap bank valuations after their dismal share price performance in 2011.

While U.S. equities were broadly resilient last year, outperforming global rivals, the weak performance of financials weighed heavily as the sector slumped 48 per cent from its peak of last February. At various stages last year, tumbling bank stocks stopped U.S. equity market rallies dead in their tracks.

“In the long term it’s hard to see how the market can have a sustainable rally unless bank stocks recover,” said Sam Stovall, chief U.S. equity strategist at S&P’s Capital IQ. “If investors don’t see healthy banks, they have doubts for a broader economic recovery.”

The importance of the financials sector within the S&P has declined since its peak weighting of 22 per cent in 2006, but it still remains a key segment of the broad market. At 13.4 per cent, the S&P financials group of 80 stocks is now the second largest sector after technology’s 19 per cent share.

Apart from a few weeks in late April and early May, the trailing 20-day correlation between the S&P 500 and the financial sector has been above 0.7 all year, according to data from S&P’s Capital IQ, meaning where financials led, the broader market often followed.

As 2012 gets under way, any renewed pressure on financials could well extend that tight relationship between the sector and the broad market.

But for some investors, bank stocks look attractive entering the new year.

Jim Paulsen, a portfolio manager at Wells Capital Management, recently decided to increase his exposure to financials citing compelling valuations and strong balance sheets.

For example, when shares of Bank of America closed below $5 (U.S.) on Dec. 19, the stock was trading at just 3.5 times trailing 12 months earnings. That represents a discount of 77 per cent to its book value – the price the company’s assets could be expected to fetch in a fire sale. In 2011, B of A shares fell 58.3 per cent to $5.56.

The S&P financials sector trades at a price to book ratio of 0.89 times, or less than the value of its stated assets. This low ratio suggests that investors do not trust the value of bank assets and expect writedowns over time. But, historically, such a low price to book ratio has attracted value investors who patiently bide their time waiting for vindication.

“U.S. financial stocks … more than any other sector have a huge ‘fear discount’ in them which could ease should confidence build,” Mr. Paulsen said.

Cheap prices and low valuations have led Goldman Sachs’ bank analyst Richard Ramsden to rate shares of Bank of America, as well as those of JPMorgan Chase , as a “buy.”

Other key U.S. banks such as Citigroup and Wells Fargo also trade cheaply with their stocks down 44.4 per cent at $26.31 and 10.9 per cent at $27.56, respectively. JPMorgan has a price-to-book ratio of 0.6 and its stock price fell 21.6 per cent to $33.25 in 2011.

Turning to the last remaining bulge bracket investment banks, Goldman Sachs dropped 46.2 per cent to $90.43 last year, while Morgan Stanley trades at $15.13, a fall of 44.4 per cent in 2011.

But to break through the current gloom over financials, investors need to believe that there is some possible upside for U.S. banks.

Mr. Ramsden points out that the improving U.S. economic outlook has allowed banks to increase lending, using record low Federal Reserve lending rates to boost margins. He also expects U.S. banks to cherry pick assets from de-leveraging European banks at a discount and claim market share in commercial lending.

“While the European bank and sovereign crisis has caused turmoil in global financial markets, there have been several positives for U.S. banks,” said Mr. Ramsden.

Some of those positives, which include improving balance sheets and capital increases, may bode well not only for financial stocks in Wall Street, but also for banks in the credit markets where they still borrow at higher rates than similarly rated companies.

“Volatility is likely to remain high and there’s still risk, but [corporate bond]spreads have widened so much that there’s definitely room for some outperformance in the sector next year,” said Shobhit Gupta, credit strategist at Barclays Capital. Barclays’ credit analysts currently have a market-weight stance on US high-grade banks.

J.J. Kinnahan, chief derivatives strategist at TD Ameritrade, agrees.

“The market has thrown everything it can at U.S. financials and they’re still standing, and on a global basis they’re standing tallest in the room,” Mr. Kinnahan said. “If investor money comes out of tech stocks and is looking for a place to go, it could well end up in financials.”

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