Bank valuations stuck at 2009 lows for good reasons

With bank CEOs heading for Davos in Switzerland to talk up their business prospects this might not be the best moment to be bearish about financial stocks. But S&P financial stocks are currently trading at 12.3 times forward earnings, close to the lowest valuation seen in the rally since March 2009.

Last week shares in Goldman Sachs, Citigroup and Bank of America all plunged after disappointing fourth quarter results. The problem is that many key areas of the banking business are in trouble and the sector is still contracting.

Mortgage business

Lest we forget amid rallying cries from Wall Street cheerleaders, the US housing market is still in a desperate slump and house prices are still falling. This has brought home lending to new lows.

Plain old credit card issuance and auto loans are also still down. Auto sales are still 25 per cent off pre-crisis levels. Then again capital markets and mergers and acquisitions have been relatively quiet.

Moreover, mortgage foreclosures are only set to peak this year, so the pain of bad debts continues, and there is mounting uncertainty about the legality of these foreclosures because of the way loans were packaged into securities, leaving the ultimate identity of the lender unclear. Then there is the new derivative clearing house that will cost the bank billions made previously from privately negotiated swaps.

This kind of uncertainty is the sort of thing that stock markets hate. Besides the whole financial sector clearly became too big and bloated in the boom and the bailout is widely seen as a temporary solution that has merely delayed a much larger process of consolidation and downsizing.

CEO challenge

Bank CEOs in Davos have to first convince clients that the world economy is really recovering and that a euro zone crisis and Asian inflation is not about to plunge us back into chaos; and then argue that their own business problems will be speedily resolved in a climate of low growth rates and increasing regulation.

As a stock market investor you have to therefore conclude that current bank valuations might actually be erring on the optimistic. Why should an industry facing this sort of future be valued on a price-to-earnings ratio of 12.3 when contracting sectors with uncertain futures are more commonly rated around six?

Shorting financials looks more of a winner than holding this stock but maybe not this week. The next edition of the ArabianMoney newsletter will consider this strategy in depth (click here to sign-up)