Bank ETFs Poised for Rebound

by Anthony Mirhaydari | June 16, 2011 5:35 am

Stocks and other risky assets are trying to stabilize near their March lows — but they’re limited by the sustained selling pressure hitting bank stocks. If a medium-term rebound rally is to develop, it must be led by financial issues.

A rebound here by bank stocks would be a huge positive for the overall market. Typically, financial stocks pull the rest of the market around likes it’s on a leash. The past few months have been no different. Financial stocks peaked in late February and have plunged ever since, pushing the Financial Select SPDR (NYSE: XLF[1]) down 14% from its February high.

Investors are worried about slow loan growth, regulatory burdens related to the Dodd-Frank bill, and new more stringent international capital requirements (known as Basel III). But the bad news has already been discounted and there are signs that the tide is turning.

Loan growth is poised to reaccelerate thanks to labor income growth, a falling savings rate, less stringent credit requirements, and negative “real” or inflation-adjusted interest rates. Regulators are relaxing their grip. The implementation of new rules for the $600 trillion derivatives market have been delayed.

And last week CNBC reported that a “secret meeting” in Frankfurt of global banking regulators was considering lower capital charges for the largest banks.

Before, so-called “systemically important financial institutions” or SIFIs, were set to hold as much as 3% in extra capital requirements  — on top of the 7% required by new “Basel III” requirements for all banks. The extra charge is to ensure that “too big to fail” banks won’t have to be bailed out. And it is also designed to try to keep banks from becoming too large.

Discussions on the SIFIs are fluid with a more formal meeting expected in Switzerland next week.

This is one of the most important reasons why financial stocks have been under such crazy selling pressure. Morgan Stanley analysts note that the likes of Citigroup and Bank of America have been trading as if investors have priced in a 14% capital ratio. The CNBC report would put the actual requirement much lower.

There’s more. Housing could be poised for a turnaround as month-over-month price declines slow. Citigroup analysts are looking for home prices to start climbing higher in the June or July data. And as shown in the chart above, even the weakest banks are unlikely to need to conduct further capital raises. Bank of America (NYSE: BAC[2]), according to Citigroup (NYSE: C[3]) analysts, should maintain reserves well in access of requirements even when assuming a 3% SIFI charge.

And let’s not forget that banking can be an incredibly profitable business to be in, especially in times of near-zero short-term interest rates like now. And as loan demand picks up, earnings growth will only accelerate.

Overall, it seems that much of the bad news has been discounted. And with news flow beginning to surprise to the upside, there is great potential for a big run higher in bank stocks.

As a result, I think valuations have fallen to attractive levels. Bank of America is trading at a 15% discount to tangible book value. Moreover, analysts don’t believe BAC will need to raise additional capital (a positive) and that its underlying business can support a healthy 14% return on equity.

For easy exposure, I recommend two ETFs: the KBW Regional Banking ETF (NYSE: KRE[4]) and the KBW Capital Markets ETF (NYSE: KCE[5]). The KCE fund, shown above, holds Wall Street heavyweights including Morgan Stanley (NYSE: MS[6]) and Goldman Sachs (NYSE: GS[7]).

For more leverage, I’ve already recommended the Direxion Financial 3x Bull (NYSE: FAS[8]) to my newsletter subscribers[9], which returns three times the daily return of the Russell 1000 Financial Services Index. The position is up more than 7% since my recommendation on June 10. I believe the gains will continue.

 

Disclosure: Anthony has recommended FAS to his newsletter subscribers.

Be sure to check out Anthony’s new investment advisory service, The Edge. A two-week free trial has been extended to Investorplace readers. Click the link above to sign up.

The author can be contacted at anthony@edgeletter.com[10]. Feel free to comment below.

 

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