Don't bank on banks

The banking sector is the biggest in the FTSE and also one of the cheapest. So should you buy in? Not yet, says James Ferguson. The technicals tell us to wait.

Nearly a third of the FTSE 100 is made up of the banking sector. This means that deciding what to do about bank stocks is the single most important equity decision each portfolio manager will make this year. It also means that if you own any sort of tracker or UK fund investing in larger firms, the direction of the sector will make all the difference to your final returns this year. It is thus frustrating to note that the two main tools in our decision-making armoury - technical and fundamental analysis - are suggesting entirely different futures for banks. The technicals look very poor and suggest the market is still fearing the worst from the housing bubble fallout. Yet at the individual stock level, the major banks are looking fundamentally very attractive. The sector has been locked in indecision for a few years now and can't make a real move until this deadlock is broken: only once fundamentals and technicals are both pointing in the same direction will things become clear.

Over the past few years, the banks have been a bit of a disappointment, as investments with steady gains have all too often given up in sudden sharp sell-offs - such as in 1998, 2000 and 2002-2003. However, the sector owes its dominance within the FTSE to its outstanding decade-long run from 1990 on, which saw it triple relative to the rest of the market. Any chance that sort of performance could kick in again has to be assessed very carefully, as does the catastrophic possibility of a return to the much lower levels relative to the market that we last saw in the late 1980s.

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What makes banks tick?

If we are going to get a grip on this situation, the first thing we need to do is to remind ourselves of what makes banks tick. Banks engage in a lot of activities, but their main role, of course, is to lend out money. They borrow from each other, or the central bank, at a cheap rate and they lend on to businesses, homebuyers and compulsive credit-card shoppers at ever higher rates. As the mix of their lending business moves towards the riskier end of society (the shoppers and the over-extended), the banks increase the mark-ups on the money (ie, the rates of interest) in order to compensate themselves for the rising risk of default.

Banks all have to keep reserves of money to deal with bad debts, to which they have to add additional funds if they see an increased chance of their customers defaulting. Increasing bad-debt provision not only eats into declared profits (provision can't be profit), but because the total amount of money that the bank can lend is a fixed proportion of their reserves, it cuts down the amount of new business the banks can write. This in turn means that, left to their own devices, the banks may not be quite as prudent with their reserves as they should be. So the Bank of International Settlements (BIS) makes the rules on provisions for them. The problem with this is that these rules are less than clear about how to treat derivatives, and some people, such as US market guru Warren Buffett, fear the next big systemic (market-wide) crisis will stem from a major bank's derivative trading book going bad and turning out to be less than completely hedged.

How the cycle works

At the start of this economic cycle, when company balance sheets weren't in great shape, there was big demand for credit from businesses, but now, with corporate profits (both here and in the US) at near record highs relative to GDP, companies just don't need so many loans. Besides, increased securitisation of the debt markets now means that bigger companies can borrow cheaply by issuing bonds or other debt instruments by themselves. The banks are therefore being forced to look to less secure borrowers to take their money. This is the way the cycle usually works and it explains why, on a long-term basis, banks can be so very volatile. Theirs is a very geared business. In the good times (eg, the last 15 years) fewer and fewer good-quality companies need to use the banks.

Thus the banks find themselves lending to potentially ever more marginal borrowers, such as households and foreigners. Think, for example, how easy it is today to get a buy-to-let mortgage. Yet in 1993-1995, when I was running three small residential-property funds, none of the high-street banks would lend development capital as a matter of policy to any developers until the collateral properties were built and let, with a proven income stream. And that was after property collateral values had slumped already, theoretically making further downside less sizeable and the risks considerably lower. The result is that, at some stage, higher profits stop looking like such a good thing to investors and start to indicate potentially higher risk instead. That's pretty much what is happening now: note the deafening silence that greeted the record earnings announcements recently made by the sector. The market knows that, when slumps come, loan defaults can quickly eat into reserves, forcing banks to curtail their business. As recently as 1992, there were fears that Barclays might go bust because of the nearly £1bn in losses it was feared it might have made on its commercial property lending book.

It's about bonds

Another thing that helps make sense of the sector and its cycle is understanding that the relative outperformance of the sector has to a large degree been driven, since 1992, by one outstanding factor, and that is the bond market. As inflation fears have subsided over the years, long-term interest rates have fallen and the banks have therefore made money at the expense of the rest of the economy, because both risk and reward have improved. Falling rates improve risk because fewer borrowers default during falling interest-rate cycles. Meanwhile, the loan spread actually expands because banks' loan books move down the quality curve and this boosts their profit reward (they charge lower-quality borrowers higher rates).

One other thing to keep in mind is that banks, like bond holders, are lenders, and like all lenders, they benefit most when inflation is weakening and the value of their loans isn't being inflated away. Fast-forward to today and it's clear that inflation is now more of a concern: the bond market, as a consequence, stopped rising back in 2003. Today's 10-year gilt yield of about 4.8% is the same as it was back in September 1998. This in turn means that there has not been the bond market follow-up support to the leap in the relative performance of the banks seen back in 2000 and 2001, when the smaller tech-type stocks were collapsing. That doesn't bode well.

All this seems to explain the otherwise very confusing picture emerging from the banking sector. On the one hand, earnings have been rising steadily now for three to four years (even longer in some cases), yet on the other hand the sector has done nothing compared to the market since early 2002, and there is a strong technical case to say that, relative to the FTSE 100, it has rolled over after a major 2002-2003 double-top and is now in a new, possibly long-term, downtrend. That suggests to me that there is now potential for the sector as a whole to fall back quite some way.

But there's more to the story

While there are signs of trouble ahead for the sector as a whole, that doesn't mean that the sector is uninvestable. Earnings aren't just driven by bond-market effects. These days, the better banks have diversified and secured solid overseas earnings: they are true multi-national conglomerates, and that may well mean that the old relationship with interest rates and the UK economic cycle is weaker than it once was. It may be that the lessons from the past have been learnt and loan books are better protected now than they were in the late 1980s. The state of the housing-loan market provides some evidence of this: the Council of Mortgage Lenders' (CML) spokesmen talk the talk and are happy to keep up the mantra that they aren't worried about a housing crash; member banks seem less willing on the evidence to walk the walk. Estimates of average mortgage loan-to-values (LTV) are lower this cycle than at the 1989-1990 peak, and are around 75%. This means, on average, even for new loans, property values have to fall by a quarter before the banks lose any of their own money. Banks were much more complacent before the last housing crash: LTVs were over 85% in 1989.

We should also consider the fact that p/e multiples for the sector are remarkably consistent, all grouping around a pretty cheap ten times. Some should be cheaper. The likes of Alliance & Leicester, Northern Rock and even Lloyds TSB should not trade on the same multiples as the blue-chip sector leaders - these are the stocks that would seem to be most vulnerable to a severe housing-related domestic downturn (something I still expect to happen). However, some should be more expensive (within the last six years, HBOS, RBS, Barclays and HSBC have all traded at p/es as much as twice today's level). So which ones are they? Below, we consider the prospects for four major banks. You probably shouldn't buy any of them now, but it won't be long before the technicals start to reflect the fundamentals. Then you should buy.

Four banks to keep an eye on

Barclays

Barclays' share price recently failed to break past its old 2002 high, even though its earnings-per-share (EPS) outlook is about 25% above what it was back then. It is unlikely the share price will fall below £5 before it has another attempt at assaulting the £6 barrier, but it could still be rather weak for the next month or two.

The fundamentals look good, but until the technical signals also point upwards, it'll be a frustrating stock to be in. Eventually, though, the EPS rate of growth and the p/e approaching single digits should push the share price through the barrier, and once it gets above £6 the move on to the £7-£8 range should be much faster. Wait for the technical move and then buy.

HBOS

The HBOS share price is lower today than it was in early 1998. Yet if you had owned a time machine back then, you could have scooted forward seven years to early 2005, quickly confirmed that the EPS was set to rise on an almost unbroken track over the entire period, and would end up more than double the level you had left it at.

If you'd also managed to confirm that gilts, which were yielding over 6% when you left, had fallen to 4.8% by March 2005, you would have been forgiven for betting the ranch that the HBOS share price would have gone up. But it didn't, not over the entire seven-year period. HBOS could fly once it gets past the seven-year resistance, but that will require the market to feel calmer about any fallout from the housing bubble. Wait for that to happen.

Royal Bank of ScotlanRBS has enjoyed much the best track record of the majors in terms of its share price following the lead given by EPS growth. Yet even RBS is still trading well below its 2002 peak share price and shy of where EPS forecasts suggest it should be. As with any investment opportunity, the fundamentals tell you what to do - in this case, buy - but the technicals tell you when to do it. The trouble with this one, as with all the major banks, is that the technicals are still ambivalent. Clearly, the market is waiting to see what the housing slowdown will do to the economy in 2005 to see how badly the banks' EPS outlook might be hit. Investors should wait too.

HSBC

HSBC is the cheapest of the banks, trading on about seven times this year's earnings. In the last 12 months, the consensus earnings forecast has surged by more than 30%. However, the share price has stubbornly refused to respond to this and hasn't moved at all. If the earnings slowdown from the housing slowdown doesn't materialise, then HSBC will look very cheap indeed. However, to my mind the slowdown is inevitable and that means that HSBC, like all the other banks, will only move when the market is better able to assess just how bad the damage might be this time round. Since the banks were hit pretty hard in 1990 (RBS's price nearly halved in the first nine months of 1990), it is perhaps hardly surprising that the market is cautious. Investors should, however, be watching closely for signs that things are not as bad last time as this time round. Be ready to buy if you see such signs.