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Why Have US Financial Stocks Done So Well In 2012?
Malaysia Perspective | 30 April 2012
By:

By Yeoh Mei Kei

Following a torrid 2011 where US financial stocks declined by 18.5 percent, the sector has posted a strong rebound in 2012. As of 16 March 2012, the Standard & Poor’s (S&P) 500 Financials index posted a strong 21.1percent year-to-date gain, significantly outpacing the 11.7 percent return for the broader S&P 500 index (return are in US dollar terms, excluding dividends). From the October 2011 lows, the financial sector has posted an even more impressive gain; US financial stocks have gained 37.6 percent, substantially more than the 27.2 percent return for US equities over the same period (see Chart 1).

Chart 1: Financials Outpacing The Broader Market Since October 2011

Why have US financial stocks done so well this year? In this article, we discuss a few key developments which have contributed to the strong performance of the sector, while also assessing the sector’s attractiveness to investors following the strong rebound this year.

Greece’s Orderly Debt Restructuring Eases Concerns Over A Financial Crisis
While the recent announcement of a successful Greek debt restructuring had broad-based positive implications for riskier assets, financial stocks have been a key beneficiary, with the avoidance of a Lehman-type situation (which may have been brought about by a “disorderly” default) alleviating concerns that credit markets would seize up and hurt sectors with high leverage and ongoing refinancing needs (like the financial sector). As evidence of improved sentiment in the financial sector, credit spreads on US banks have narrowed significantly from a recent high of 367.70 basis points in November 2011 (see Chart 2) to 234.50 basis points (as of 16 March 2012), highlighting the lower perceived risk of default by financial institutions.

Chart 2: Financial Sector Credit Spread Narrowing

15 Banks Cleared Fed’s Latest Stress Test
On 13 March 2012, the Federal Reserve released results of its stress test on 19 ‘large, complex bank holding companies’. The test was relatively onerous, involving situations where US home prices decline a further 20 percent from current depressed levels alongside a 50 percent decline in the US equity market. Just four institutions failed the test (with their capital ratios falling below acceptable levels under test conditions), with the majority of test subjects passing. Given the stringent nature of the stress test, the release of the test results lends much credibility to the ability of large US banks to survive, even under rather trying economic and financial market conditions.

The 15 bank holding companies which passed the Fed’s latest stress test have also received approval to return capital to shareholders, via various plans for dividend increases and share-repurchases. For example, JPMorgan Chase was given the green light to embark on a US$15 billion share buy-back programme (which represents almost 9 percent of the bank’s outstanding market capitalisation, as of 16 March 2012), along with a dividend increase, while American Express is scheduled to repurchase US$4 billion of stock in 2012 (about 6 percent of its outstanding shares). These represent significant moves to enhance shareholder value (especially if share-repurchases are carried out at a discount to book value), and has contributed to the improving investor sentiment on the sector.

US Economy Recovering
Bank profitability is correlated with the health of economy, as lending activity picks up in economic upturns while downturns bring about higher non-performing loans. There has been much concern over the ability of US banks to grow their loan books in an environment of prolonged economic weakness, weighing on the performance of financial stocks. Nevertheless, concerns about the US economy slipping back into recession have faded significantly in recent months given the strength in two key areas – the job market and the housing market. Led by private sector hiring, nonfarm payrolls have seen the addition of nearly 3.5 million jobs since March 2010, averaging a 144,000 increase per month. Hiring appears to have been gathering strength in recent months, with latest data indicating that 284,000 and 227,000 jobs were created in January 2012 and February 2012 respectively (see Chart 3).

Chart 3: Jobs And Housing On The Mend

Even the beleaguered housing market appears to be turning the corner, with residential investment adding 0.25 percent to the overall gross domestic product growth figure of 3 percent in fourth quarter of 2011, and poised to become a more significant contributor to US economic growth as housing starts rebound from their current depressed levels.

Book Value Has Begun To Grow, Valuations Still Supportive
Following the 2008 to 2009 global financial crisis, US financials took huge write-downs on their assets, with book value for the sector declining a hefty 31 percent in 2008. Since then, a return to profitability by the sector has boosted book value (see Chart 4), with further increases expected over the next three years. Despite the strong rally by US financials so far in 2012, the sector still trades at just 1.06x book (as of 8 April 2012), a deep discount to the long-term historical average of 1.98x (see Chart 5). In addition, with the sector trading so close to book value, there appears to be little ascribed to the potential for US financial institutions to grow book value or profits over time.

Chart 4: Valuations Of US Financials

Chart 5: Book Value Expected To Growth

Yeoh Mei Kei is a Research Analyst at Fundsupermart.com.


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