Don’t Bank on These Shares for Awhile

SAVVY INVESTOR

Shares of financial stocks have been hobbled and could get a whole lot cheaper

Alex Roslin
The Montreal Gazette
Monday, November 12, 2007

[Click on chart to enlarge.]

How the mighty banks have fallen. As visions of subprime meltdowns dance in investors’ heads, shares of Canada’s once-mighty banks have been hobbled, while the U.S. financial sector is in an open rout.

The widely watched KBW Bank Index, a basket of leading U.S. banks, is in a freefall, plummeting 23 per cent since its peak last February and shooting down to almost pierce its low of 2005.

That qualifies U.S. banks as being in a bear market, usually described as a 20-percent price drop.

Even here in Canada, which so far has escaped largely unscathed from the U.S. real-estate crack-up, the benchmark S&P/TSX Financial Index peaked back in May and is down six percent.

The average Canadian bank stock is now at the same value as it was 12 months ago.

It’s all quite mystifying for a sector that has been powering steadily up ever since 2000, suffering nary a hiccup even during the 2000-02 dot-com crash.

Back in those frightful times, while the high-flying tech stocks of the Nasdaq index crumpled, shares of the Royal Bank of Canada, for example, took off from around $13.30 in January 2000 to peak at more than $60 last May. (They’ve since drooped to below $52 as of last week.)

Meanwhile, the Nasdaq, despite its remarkable recovery since 2002, is still nearly 50 per cent below its 2000 high.

But just when it seemed like nothing could thwart bank shares in their ascent, along came the U.S. housing disaster, which has left many banks facing their own stock disasters. Is there any hope now for a turn in the tide?

Probably not yet, say some market chart experts.

“There are definitely major weaknesses in that area,” said Ron Meisels, president of Montreal-based market-analysis firm P&C Holdings and a founder the Canadian Society of Technical Analysts. (Technical analysis is the study of market charts to spot price trends.)

Meisels called the performance of U.S. banks “an absolute disaster. It seems the market is telling us there are still some problems that are not yet announced. The important thing is we’re not aware of the total cost of the real-estate writedowns to the banks.”

Meisels said many long-term investors are hesitant to dump bank stocks because, in past selloffs, they’ve always eventually recovered. He said that’s a reasonable argument, but he advised closely watching a security’s 200-day moving average.

(Charts of stocks and indexes, including moving averages, can be generated at various free websites, including Yahoo! Finance and StockCharts.com.)

If the price falls decisively below the 200-day average, that’s a bad sign, he said. The S&P/TSX Financial Index has seesawed below and above that line since last July.

Especially important, he said, is whether the 200-day average is sloping upward or downward. While the TSX financial index is still pointed up, three of the big six Canadian banks have seen their 200-day averages go flat in the past one or two months, while those of the Bank of Montreal and National Bank have been in an outright decline since August.

“It’s a bad situation,” said Mark McClellan, a bond analyst with Montreal-based BCA Research who used to work for the Bank of Canada.

McClellan believes credit-rating agencies “are still early” in the process of re-evaluating bank balance sheets to account for poor-quality or defaulted U.S. housing loans.

Even when that process is done, he said, as long as U.S. house prices keep falling, the rating agencies “will have to go back and redo the ratings again.”

All this means that, while bank shares have gotten cheap, they may only be at the beginning of their decline and could get a whole lot cheaper.

“There’s probably more to come. The markets are usually forward-looking, but not this time. There’s no price transparency (to the banks’ real estate debt),” McClellan said.

While U.S. house prices are already down five percent since they peaked in June 2006, according to the S&P/Case Shiller U.S. National Home Price Index, McClellan predicted a further decline of “at least another 10 percent” over several more years.

That jives with a New York Times report in late October that cited economists predicting an additional U.S. house-price drop of 10 to 20 percent, with an eventual $2 to $4 trillion wiped out in real-estate wealth.

The good news in the horror story is the financial sector’s misery is all but certain to prompt more monetary easing from the U.S. Federal Reserve Board and Bank of Canada, McClellan said, which will push interest rates downward for everything from mortgages to car and business loans.

The Bank of Canada, in particular, is also feeling pressure to reduce rates because the soaring Canadian dollar is prompting some retailers to lower prices of U.S. imports, which should cause Canadian inflation to “plunge,” according to a recent research note from BCA Research.

Falling inflation should be good news for Canadian bonds, which would rise in value as interest rates fall, BCA Research said.

Lower inflation and interest rates should eventually also buoy Canadian bank shares, but McClellan said U.S. banks, for their part, are unlikely to end their decline until house prices south of the border have stabilized.

Looking at the charts, Meisels said Canadian banks could see a recovery bounce in coming months, but they’re still likely to underperform the broader market, particularly commodities.

The key level to watch is whether financials manage to surpass their highs of last spring, he said. If they do, Meisels said he would become more bullish on the banks, but he said he doesn’t think that’s likely.

Instead, he predicted the sector will meander up and down for the next two years. And then, he said, look out. Meisels said his research into the history of investing patterns suggests the entire market, including banks, is due for a “big shellacking” in 2010.

MORE COMMENTARY:

Ron Meisels expects the current 40-year market cycle to end in a gruesome bear in 2010 that he believes will last to 2014 and will have similarities with the last such cyclical downturn between 1973 and 1982.

If this gloomy scenario actually unfolds, he said he expects to see a further drop of about 20 percent in bank stocks from today’s levels.

FOR MORE INFORMATION:

BCAResearch.com: daily free market brief

StockCharts.com: free charting website