I confess that I occasionally yield to the temptation to mine through data in order to make some point or another. In this line of work, who doesn’t? So it’s with no small amount of pride that I present the following chart, which compares the strength of the economic recovery following the 1981-1982 recession with what’s been going on in the economy lately. See the similarities?:
Oh, stop your squawking. No, the masterpiece above isn’t proof positive that the economy is about to reprise the economic boom of the 1980s. But it is a useful reminder that, regardless of what the gloomsters might say at the time, the economy can accelerate pretty darn quickly even out of the dreariest economic circumstances.
Here we are, 18 months after the darkest days of the Panic of 2008, and one is struck by how much progress has been made in getting things back to normal. Go ahead and pooh-pooh my back-to-the-‘80s chart if you’d like, but the economy really did grow at a 5.9% annual rate last quarter, after growing at a semi-decent rate the quarter before that. The consensus for growth for the year is 3.0%, and is on the rise.
String enough quarters like the last one together, and pretty soon you’ve got an actual economic recovery on your hands. Not a U-shaped recovery, or an L-shaped one, but the sort of robust economic expansion that, not so long ago, everyone was assuring us wasn’t possible.
Or look at credit spreads. They roared to harrowing, undreamt-of heights at the end of 2008, but lately are looking positively benign. You’ll have your own favorite number (the TED spread, perhaps) for measuring the level of jitters in the financial system. For myself, noodling through the Bloomberg just now, I came across the wonderfully named “HSBC Clog Index,” which seems to be a hit parade of the most popular measures of the financial yips, from the TED spread, to CDS prices, to the VIX, all mixed together into into a single, glorious, potentially ulcer-inducing number. Except that if you look at the Clog Index lately, its ability to inspire fear seems to have vanished.
From the Cloggian perspective, it might as well be early 2007 again, when we were all a lot richer.
I mention all this as a longish introduction to my view on the financial stocks, which, you won’t be surprised to learn, is extremely bullish. I believe the financials are still toward the beginning part of what will turn out to be the greatest bull market in the group in our lifetimes. There is an enormous amount of money still to be made in the stocks. The fund that I manage (which specializes in financials) has been buying aggressively, and is positioned to take maximum advantage of continued strength in the group.
There are five reasons why I’m so enthusiastic:
- The economic recovery is proceeding on schedule.
- The financial panic has evaporated.
- The housing market is showing signs of recovery and improvement.
- Bank credit is showing clear signs of improvement.
- Stock valuations are extremely attractive.
As to Points 1 and 2 above, well, I’ll let recent GDP data and that HSBC clog number do the talking. They show that the economy has clearly recovered from recession, and that the financial markets, if not completely unstuck, have made enormous progress in getting back to normal.
As has—getting to Point 3—the market that did so much to cause all the trouble in the first place: housing. The recent improvement in the Case-Shiller Home Price Index (the closest thing the housing market has to an S&P 500) is widely known. After bottoming last April, the index as move steadily higher ever since, while the number of cities where prices are still falling has gone steadily down.
More to the point, even markets hardest-hit by the housing collapse are starting to show signs of life. In Orange County, California, for instance, near ground zero in the home price implosion in Southern California, sales are booming, and prices have actually been rising for months.
In Florida, which was hit even harder than California, the meltdown has stopped and a turn looks ready to begin any minute.
The stabilization of home prices is enormously bullish for the financials, especially mortgage-related companies. Once prices move higher in earnest, mortgage credit quality should improve, too, as more borrowers will be able to refinance rather than face foreclosure. Strategic defaults will cease to be a concern. “Jingle mail” will no longer be part of the popular lexicon. A rise in homeowners’ equity will boost household liquidity and help the economy generally.
And if mortgage credit looks be ready to improve, so does (Point 4) bank credit generally. The past few weeks have brought pretty clear evidence that the rate of new delinquencies in credit cards, for example, has slowed materially while cure rates of earlier delinquencies are rising. The story’s the same in auto loans. Yes, commercial real estate remains a challenge—but the structure of the CRE market makes workouts there a lot easier than they are in residential lending. (For one thing, even a delinquent commercial property throws off cash flow that can service debt at some level; a delinquent single-family home, by contrast, does not).
Probably the single number that best illustrates the state and direction of bank credit is the dollar amount of new loans entering non-performing status. Fewer bad new loans on the front end means lower chargeoffs down the road. And on the new-NPL front lately, the numbers have stabilized and seem to have negun to improve. Here are aggregate new-NPL flows for all banks above $2.5 billion in assets:
What’s more, a number of banks have recently revised their guidance, and have indicated they expect new NPLs to decline by more in the current quarter than earlier thought.
That’s extremely bullish. Once chargeoffs start to fall, bank profitability figures to boom. Reason: loss-provision expense will plummet, to reflect the brightening credit picture, to the point where, eventually, reserves will be reversed outright. That’s what happened over the past two cycles, at least:
More generally, loan losses this cycle have come in a whole lot lower than many feared they would. Remember that stress test that the government forced the big banks to go through last year? Now, a year later, it’s clear that losses were nothing like what some people had in mind. Here are losses year-to-date for the big banks, compared to the “adverse case” loss projections embedded in the stress tests. As you can see, it’s not even close:
So here is where we are: The economy is expanding again and the credit markets have largely thawed. Nationwide, housing is on the mend. At the banks in particular, key leading indicators of credit have begun to improve, and the rate of improvement seems to be accelerating. If life isn’t exactly back to normal in the banking business yet, it’s not hard to imagine a time, fairly soon, when it will be, and when banks will be generating profits at their normal earnings power.
In all, it is a very bullish outlook, in my view--and yet, oddly, the financial stocks don’t seem to be priced to reflect any of it. The best way to value bank stocks at this point in the cycle is to look at them relative to book value, or tangible book. And by those metrics, the stocks are still scraping along near their lows. In normal times, recall, financial stocks might typically trade at anywhere between 2 and 3 times book value. Lately, by contrast, it’s not hard to find banks trading well below book value. Take a look:
So values are thick on the ground in the financial sector, in my view. The most compelling buys, I believe, are among small- and mid-sized regionals that are at last starting to recover from (sometimes severe) credit problems. They were among the stocks that fell by the most during the financials’ collapse in 2008 and early 2009. Many of the companies have made enormous strides in addressing their credit issues, and are starting to see real improvement. Among the names we own in our portfolio are CoBiz Financial COBZ), Fifth Third (FITB), Synovus Financial (SNV), Taylor Capital (TAYC), and Zions Bancorp (ZION).
More broadly, as I say, the bull market in financials has a long, long way to go, I believe. The improvement in the groups’ fundamentals is too clear, and the valuations too low, for the stocks’ prices to go anywhere but up.
What do you think? Let me know!