Should I Buy Financial and Banking Stocks Now? October - November 2008 Repors

Are stock valuations based on 2009 estimates really cheap?

Overall, analysts now see earnings for companies in the Standard & Poor's 500 falling 4.1% year-over-year in the recently completed third quarter. That is a major reversal from the outlook of just a month ago, when the consensus estimate called for a gain of 6.8%, and almost 20% worse than the average expectation at the beginning of quarter. Yet, analysts are still looking for 2009 profits to post strong year-over-year gains of 34%, leading us to believe that (outside of the financial sector) current estimates do not yet reflect negative impact from the liquidity squeeze and economic slow down. This over-optimism is also evidenced in sector outlooks, which have not seen meaningful changes over the past few weeks and now appear to be overdue for an adjustment. October economic data is coming in grim. The Philly Fed Activity Index for October fell off the cliff, plummeting to -37.5 from +3.8, for the worst reading in 18 years, and the guidance from major domestic companies could hardly be called good news. GE shares notched an 11-year low after the U.S. economic bellwether posted a 22% drop in net income. “The global economic environment is tough," said CEO Jeff Immelt, and GE confirmed its 2008 forecast of a profit drop of up to 12%. Valuations based on optimistic earnings forecasts can look attractive, but investors must remember that low P/E ratios are not sustainable if the denominator (the "E") is cut due to reduced earnings forecasts going forward.

Is it time to target banking bargains?

The Treasury once again expanded its bank rescue efforts, going beyond buying bad assets on bank books, by using some $250 billion from the bailout bill’s $700 billion to take direct stakes in banks it thinks are “too big to fail.” To unlock credit markets and spur new lending, nine banks, termed “healthy” by the government, will receive about $125 billion, including Bank of America, Citigroup, JP Morgan, Wells Fargo, Goldman Sachs, Bank of New York, Morgan Stanley and State Street. Bank of America, Citi, JP Morgan and Wells Fargo will receive investments of $25 billion each while Goldman Sachs and Morgan Stanley will get $10 billion each. The remaining $125 billion will be allocated to smaller regional banks. In turn for the recapitalization, the government will receive preferred stock paying a 5% dividend that will rise to 9% in five years. The government will also receive warrants totaling 15% of the preferred investment. And the government will have more say over day to day banking operations. As part of the Paulson plan, the Federal Deposit

Insurance Corp will take the unusual step of insuring senior debt issued by banks and thrifts for three years. Beaten down bank shares rebounded as news of the plan buoyed confidence in the safety and soundness of the U.S. banking sector. But from an investor standpoint, the plan benefits will largely accrue to bondholders in the sector over stockholders. Once the “relief rally” subsides, we expect bank stocks may continue to suffer as poor operating results and the dilutive effects of additional shares combine to deliver disappointing earnings into 2009. Two weeks ago, Bank of America reported a brutally bad third-quarter and slashed its dividend. Last week, JPMorgan Chase said quarterly profit fell 84%, due to underperforming loans. Wells Fargo profit fell 25%, and Citi lost $3.4 billion on an operating basis—and losses could continue into next year.