Bank Stress Test Stocks: Buy, Hold or Sell?

NEW YORK ( TheStreet) -- The results of the bank stress tests to be announced next week is expected to further ignite bank stocks, but given the sharp run-up in prices in the last two months and continuing overhang from Europe and regulatory issues, investors may have reason to be cautious.

The Federal Reserve's Comprehensive Capital Assessment and Review is an annual test conducted by the regulator to assess whether the country's largest banks can withstand a massive shock to the economy.

Banks will have to show that they can still maintain a Tier 1 Common Capital ratio of at least 5% even if they end up absorbing substantial losses in the event of a severe economic downturn. The harsh scenario includes a GDP contraction of 8%, a further decline in housing prices of 20% and an equity market crash of more than 50%.

Banks will also have to show that they are on track to meeting their capital requirements under new international rules or Basel 3.

If the Fed is satisfied with the tests, it will go ahead and approve banks' requests to return capital to shareholders, either by way of dividend increases or buybacks or both.

Analysts have largely been positive that banks will pass the stress tests and that most will win approval for their capital return plans.

"The big message that will come out of the stress tests is that American banks are highly liquid, they have an excessive amount of capital and that they can withstand a fairly sizeable setback in the economy," Rochdale Securities analyst Dick Bove told Yahoo Finance's Breakout.

"The second thing that will happen in week following the stress tests is that banks across country are going to be raising dividends and some will be announcing buybacks . I am assuming it is going to be a big buy signal for bank stocks and I will be shocked if it were not."

Still, after a 35% rally in the KBW Bank Index, the stress test may not be such a positive catalyst. The expectations of who is poised to win from the stress tests vary widely as also estimates of how much banks will return to shareholders.

Bank of America Merrill Lynch analyst Erika Penala points out that the bank stress tests might potentially disappoint. "While harsh stress-testing from the Fed was always a risk to results, a risk that we believe is less recognized by the market is that banks would be conservative with regards to capital return requests, for fear of being "rejected"," she wrote in a note Tuesday.

Last year, Bank of America ( BAC) put in a request for a modest dividend increase, only to be rejected by the Fed. This time, the bank has said it has not made a request to return capital to shareholders.

Other banks might also wish to avoid the embarrassment of being rejected and the signal that would send to investors.

Even stronger banks such as JPMorgan Chase ( JPM) have expressed some "confusion" over how much capital to return to shareholders and how much to retain on their balance sheets as they strive to achieve international capital standards sooner.

So while some analysts estimate that JPMorgan could deploy as much as 75% of its earnings towards dividends and buybacks, others such as Chris Mutascio at Stifel Nicolaus believe it will be more conservative with a payout ratio of about 50%, until it hits its Basel 3 Tier 1 target of 9.5% by 2013.

Mutascio also notes that some analysts might be too optimistic in their estimates of potential dividend and buyback increases. For instance, Keycorp ( KEY) and Comerica ( CMA) have very strong capital ratios, but they may fail to meet the Fed's criteria for pre-tax pre-provision earnings.

"We continue to believe that the relative winners of the CCAR will be those banks with relatively strong ROAs and low P/E multiples," Mutascio wrote in a recent report, pointing to JPMorgan Chase and Wells Fargo ( WFC).

Investors scouting for ideas ahead of the stress test might take some cues from the options market, according to Oppenheimer analyst Chris Kotowski.

In a Feb.28 report, the analyst calculates the implied dividends priced in in the options market. Without getting into the math, it appears that the market is pricing in a dividend increase for Citigroup ( C) at about 3 cents a quarter, compared to Kotowski's own estimate of 10 cents a quarter.

" Given the level of future dividends priced into the options market, we think that C has the greatest chance of showing a positive surprise when CCAR results are announced," he wrote.

-- Written by Shanthi Bharatwaj in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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