Cheap and Almost Growing, Banks Are Poised to Lead

Among other marvels, financial firms should post earnings gains in the fourth quarter.
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While few sectors of the stock market have offered any clear leadership this year, the banking group has outperformed on a relative basis and there's reason to believe that could continue.

The Philadelphia Banking Index has climbed 14% from its lows on Sept. 21 and has easily outperformed the broader market since the start of the year, falling 10% compared with a 16% drop for the

S&P 500

.

One reason has been the relative strength of their profits. Third-quarter earnings for financial companies fell about 17% and are projected to climb 11% in the fourth quarter. That compares with a 22% drop in S&P 500 earnings for both the third and fourth quarters.

Concerns about credit quality and weaker investment banking have clearly pressured profits for the group this year. Back in July, expectations were for a 7% gain in third-quarter earnings and a 25% gain in the fourth quarter. Still, the

Fed's 10 interest-rate cuts offered support and put a floor under financial companies' share prices.

Nice Spread

"The slope of the yield curve has been very positive," noted Chris Wolfe, equity market strategist at J.P. Morgan Private Bank. "It has been helpful as banks are paying deposit rates that are very low and reinvesting in longer-dated treasuries to capture part of that spread." In addition, nonperforming assets have "come in better than expected," he said.

Tom McCandless, analyst at Keefe Bruyette & Woods, said the relative strength in the earnings of financial companies this year may bode well for the overall economy. "While loan growth has slowed incrementally, and in some cases even declined, mortgage demand has gone through the roof," he said.

Lower rates make it cheaper for consumers and businesses to borrow money but Wolf noted that banks have tightened their lending standards this year. Meanwhile, many people who are borrowing are not necessarily investing that money but rather using it to pay down debt.

Therefore, financial institutions, traditionally leading indicators for the overall market, are not providing much insight into the direction of the economy or market right now. But they remain one of the brighter spots in a generally dismal environment and analysts believe they will continue to outperform over the near-term.

"We don't expect the banks to exhibit much relative weakness compared to the S&P 500," said Andrew Pollini, banking analyst at Advest. "In fact, the banks could prove to be relative winners over the near term, particularly in a down market environment."

Aside from superior earnings, financial companies are also more attractively valued right now.

"In our opinion, the banking industry's relative P/E is oversold," Pollini said.

The nation's 40 largest banks currently sell at about 12 or 13 times forward earnings, compared with a forward multiple of 22 for the S&P 500.

Recovery Vectors

Still, R. Jay Tejera, an analyst at Wells Fargo Van Kasper, noted that these stocks are not necessarily cheap, as 2002 estimates are still at risk. Thomson Financial/First Call is currently looking for earnings in the financial sector to climb 21% next year.

"The big question is are we going to see a V-shaped recovery or a U-shaped recovery," Tejera said. "If we see a V-shaped pattern the stocks are cheap, if U-shaped, they're probably fairly valued."

Although the economic backdrop remains cloudy, analysts say technical charts are revealing some bullish price action.

"The Philadelphia Banking index made a double top last month, hitting a high of 822 on Oct. 4 and 819 on Oct. 26," noted Ken Tower, technical analyst at UST Securities. "A break above those levels would be very positive for the sector and the stock market," he said.

Tower said smaller or mid-cap banks are showing "some really good patterns" but he also likes the look of Bank of America, which he said rose to its highest level in 19 months this year.

Phil Rettew, technical analyst at Merrill Lynch, agreed that charts on the smaller banks look more appealing right now but he also is looking for the Philadelphia Banking Index -- comprising mostly large-cap names -- to break through 822 and then climb a further 6% or 7%.

"Regardless of whether economic recovery is three months or much further away, the yield curve, liquidity and falling interest rates should be benefiting rate-sensitive sectors such as financials," noted Niall MacLeod, analyst at Shroder Salomon Smith Barney.

Still, with persistent worries over corporate profits and credit quality, uninspiring takeover activity and Fed easing winding down, it is not clear how long the outperformance of financial stocks will last.