Bank Shares Get Oversold

With analysts now calling for an interest rate hike by October, some investors are starting to worry about the outlook for financial stocks, which have been major beneficiaries of low rates over the past few years.

Although a number of banks and brokers have reported solid first-quarter earnings recently, bears say the good times are about to come to an end, arguing that higher rates will hurt business and that the group is overvalued after a big run-up over the past 12 months.

But several industry experts say these concerns are exaggerated and that nimble investors can still make money in the group this year.

"Financials are not cheap and do have exposure to rising rates, but there are still some good values to be had," said Richard Erin Caddell, an analyst at Blaylock & Partners.

Caddell noted that the average bank currently trades at around 15 times trailing earnings, which is above the 20-year average of 11.5 times. But stocks such as J.P. Morgan ( JPM) and U.S. Bancorp ( USB) are more reasonably valued and sport dividend yields of over 3%, making them intriguing investments.

Jeffery Harte, an analyst at Sandler O' Neill, also likes J.P. Morgan and said Citigroup ( C), which is poised to release earnings on Thursday, is another top pick. But Harte is actually bullish on the entire bank and brokerage sector, saying shares are fairly valued on the whole.

"When you come into a recovery, a fundamentally improving environment, they shouldn't just trade at their historical averages -- they should trade closer to prior peak valuations," he said.

Harte and other analysts say that if the Federal Reserve were to raise interest rates in the fall, it would signal that the economy is rebounding, and that would be a positive development for many financial stocks.

"Presumably, rising interest rates would only occur if and when there was economic growth," Caddell said. "Strong economic growth is going to help financials."

While a rate hike would hurt the so-called carry trade, in which banks borrow short-term funds and lend them out at higher rates, an increase in loan growth and higher investment banking activity could well offset that, according to some analysts.

Ruchi Madan, an analyst at Smith Barney, said that on average, banks would derive a 0.5% earnings benefit from a 100-basis-point rate increase. But she noted that if rates were to rise by 200 basis points or more, earnings could be negatively affected by about 2%. "We believe rapid and more meaningful rate increases may be more painful," she said.

Madan said Comerica ( CMA), M&T Bank ( MTB) and TCF Financial ( TCB) are best positioned for a rise in rates, while Charter One ( CF), Huntington Bancshares ( HBAN), National Commerce Financial Corp. ( NCF) and North Fork Bancorp ( NFB) are the worst positioned.

Federal funds futures are currently pricing in a 100% chance of a tightening by October and imply 50 basis points of tightening by year-end. Eurodollar contracts, meanwhile, are signaling that the funds rate will rise above 1.5% in the fourth quarter of this year. The short-term rate currently stands at a 45-year low of 1%.

Analysts recently raised their expectations for a rate hike in October, after a much stronger than expected jobs report for March. The Amex broker-dealer index has fallen 3.2% since the data were released on April 2, while the Philadelphia Bank Index is down 1.7%. Still, both indices are in positive territory for the year.

"The fact is, most banks are asset-sensitive and would love to see rates go up a little bit," said Michael Rosinus, general partner at the Tiedemann Investment Group. "You should definitely be interested in buying, but it's a stock-picker's market."

Rosinus said he would be reluctant to buy pure mortgage plays such as Countrywide Financial ( CFC), which will see business slow down as interest rates move higher. But companies like Citi and J.P. Morgan are poised to do well, given their leverage to the capital markets and reasonable valuations, he said.

Even Richard Bove, an analyst at Hoefer & Arnett, who is generally negative on the financial sector, said J.P. Morgan, Citigroup and Bank of America (BAC) are safe places to park cash.

"Earnings will go up, their dividends are high, multiples are low, and they have a strong recurring stream of revenue," he said.

Bove recently downgraded most stocks under his coverage because he believes that the 20-year period of declining interest rates has come to an end and that rates are likely to move up over the next 10 years.

"If rates aren't stable, the market can't go up," he said, adding that he expects a 200-basis-point increase in rates over the next year.

To be sure, investors in the financial sector must be selective this year. Companies heavily tied to the mortgage market are likely to see a big slowdown in activity, and other stocks are simply too expensive to own right now. But any indiscriminate selling by investors could provide some interesting buying opportunities.

"You don't want to dump the group entirely," said Caddell. "There are good values to be had in the sector, and they'll get better if the selloff continues."

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