Bulls bet on banks after stress test boost The stars aligned this week for stock market bulls. A canard on Wall Street is that a true bull market run requires leadership from financials. This week banks powered ahead of technology shares to assume pole position among the main sectors of the S&P 500 as the benchmark rose above 1,400 for the first time since June 2008. Against the backdrop of an improving economy and signs that the housing market is gradually emerging from the doldrums, the case for buying beaten-down financials looks strong. The impetus for this week's jump in share prices came from the release of Federal Reserve stress test results on the nation's top 19 banks. JPMorgan swiftly announced it was raising its dividend by a fifth and would buy back up to $15bn of its stock. Wells Fargo increased its quarterly dividend by 83 per cent to 22 cents a share. Although four banks, including Citigroup, failed the stress tests, investors are in a forgiving mood. Financial institutions have greatly increased their capital in recent years and, on valuation metrics, their shares look attractive. The danger for investors, however, is that the regulatory landscape for banks has been transformed in the wake of the financial crisis. The heavier regulatory burden, as a result of the Dodd-Frank legislation and Basel 3 rules on capital, means that, while financials could yet rise further in the short term, the longer-term case for owning banks still looks harder to justify. Indeed, some analysts argue that the rally in financials is no more than a catch-up, following a dismal 2011. Despite a gain of more than 20 per cent this year, the sector still lags the wider market. Financials as a group remain more than 40 per cent below where they were trading in the summer of 2008, prior to the collapse of Lehman Brothers. Moreover, financials remain 8 per cent shy of their post-crisis peak reached in February 2011, a threshold that looms as the near-term objective for bulls. For now, the most compelling case for further gains is still their low valuations. Michael Kastner, principal at Halyard Asset Management said: "Financials have a lot more room to rally and, if investors conclude banks are a lot less risky, at current multiplies they are still cheap." Of the six largest US banks, only Wells Fargo trades above book value, or the price of its assets, and has done since early 2009, apart from a handful of days late last year. From 2001 to 2007, all of the six biggest banks, traded at a multiple of two to three times book value, whereas now JP Morgan and Goldman Sachs are just shy of 1. Morgan Stanley is at 0.6, Citi at 0.5 and Bank of America at 0.45. However, several analysts warn against an overly simplistic focus on valuation. "The book value of financials is inherently volatile, because so many of their assets are marked to financial markets, and have seen large paper gains this year," says Steven Schwartz, who follows insurers at Raymond James. Strip out that effect, and financials no longer look so cheap. But the boost to bank dividends and the prospect of buybacks, which do not alter the economic value of a company, appeals to yield-hungry investors. "The signal from the Fed that banks can pay dividends is crucial," says Randy Warren, principal at Warren Financial. If bank stocks can generate income, they're attractive to a whole new set of investors. The deeper message from banks returning capital to shareholders, however, is that the sector is not retaining those funds to boost leverage and increase return on equity as a result of tougher regulatory controls. Gone are the days of banks attaining an ROE of more than 20 per cent, or even higher at the peak of the credit boom, and propelling share prices higher. Regulators are focused on limiting risk taking within the industry. Oliver Pursche, a portfolio manager at Gary Goldberg Financial Services, says: "You're not going to see banks be as aggressive in their business models as they were before the crisis." David Trone, senior analyst at JMP Securities says banks need to get their ROEs up to the mid-, to high-teens from their current 9 per cent in order to return to more normal levels of profitability. He does not think that ratio will get past 12 per cent due to the regulatory environment. Tighter regulatory controls, as various rules are finalised this year, could well mean bank share prices no longer look so cheap, with Morgan Stanley trading at more than 20 times forecast 12 months earnings, and Goldman Sachs not far behind. Impressive as it has been in 2012, can this rally last? "The relief element of the rally has run its course," says Barry Knapp, chief US equity strategist at Barclays Capital, who recently advised clients to go "underweight" bank stocks and take profits. Bank stocks are in the hands of regulators.