Should Investors Buy Into Banks and Housing? We Have the Answer...

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It's been four years, but it feels to be a lot longer than that. The U.S. housing sector started to quickly deteriorate in the spring of 2008, and though many hoped industry conditions would improve in a year or two, we're still waiting for signs of life. And looking more deeply into a blockbuster agreement signed by the U.S. government and major banks last week, housing bulls may still have a considerable wait ahead of them. But for the major banks that were also decimated in the housing and mortgage crisis, last week's agreement is a huge positive that remains underappreciated.

[block:block=16]Details of the $25 billion agreement have been widely covered elsewhere, so I'll just summarize the key points:

• The big banks have agreed to large cash and non-cash liabilities, including Bank of America (NYSE: BAC ) ($11.8 billion) ; Wells Fargo (NYSE: WFC ) ($5.4 billion) ; J.P. Morgan Chase (NYSE: JPM ) ($5.3 billion) ; and Citigroup (NYSE: C ) ($2.2 billion) .

• The banks may still be exposed to liabilities relating to how loans were originated and secured in coming quarters, though that would likely be a far smaller amount than the settlement we just saw.

• Future bank earnings will be slightly diminished because some refinanced loans will carry lower rates.

• Banks have largely taken out reserves in the past against this settlement and have little or no forward write-downs to take.

It's that last point that highlights why I remain quite bullish on many bank stocks. As I've written in the past , the fact that they were selling well below book value was the result of massive housing-related damage yet to come, and potentially huge exposure to the problems in Europe. Neither of these issues is likely to weigh on banks any more in the quarters to come. Meanwhile, here's a quick snapshot of where banks are now valued in relation to book value and projected 2013 profits.

 

Valuing bank stocks in terms of tangible book value has always been a fluid target. Throughout most of the 20th century, they traded for between 1.0 and 1.5 times book value. In the past decade, this multiple often rose well above 2.0, or 200% of tangible book value. It may be a while before such lofty valuations are again spoken of, but big banks trading BELOW tangible book value is extremely unusual.

Looked at another way, banks tend to trade at a high single-digit earnings multiple at the peak of their cycle, but the multiple is often far higher when gauged against bottom-of-the-cycle earnings. The fact that many of the major banks trade for less than 10 times projected 2013 earnings, even as the potential for mid-decade profits is far higher, re-affirms that these stocks are solid bargains.

Pretty quickly, you come to understand why Citigroup (NYSE: C ) has a key place in my $100,000 Portfolio , especially when you consider that the bank has above-average long-term growth prospects, thanks to its emerging-market exposure. Simply trading up to tangible book value implies a 50% gain for Citigroup. Trading up to 1.3 times tangible book value, which is the historical mean of the last 40 years, implies a 100% gain from current levels. It will take quite some time for that to happen, but the runway is in place.

Another false dawn for housing
At first glance, the landmark $25 billion settlement with the major banks would imply great news for the major home builders. On second glance, the deal just implies more challenges to come. The banks have up to three years to sort out all of the troubled loans they are carrying, so any major relief to most struggling "underwater" homeowners may still be several quarters away. Second, this entire class of consumers remains under financial duress, and few will be in a position look at new home purchases any time soon.

The clearest outcome from the settlement is that the thousands of homes frozen by the foreclosure mess will become unfrozen, meaning that banks will finally be in a better position to start unloading distressed properties, likely through short sales. As a result, the supply of existing homes on the market is likely to swell, obliterating demand for newly-built homes.

Meanwhile, housing stocks are on fire in hopes that the market for newly-built homes will soon turn up. The Philadelphia Housing Index (HGX) has surged more than 50% since the start of the third quarter.


This sector rally not only overestimates the still-tough housing environment in 2012, but already accounts for some of the upside that we may see in 2013 as housing indeed starts to perk up. [I looked at some specific housing stocks that may be especially ripe for a pullback last week.]
 
Risks to Consider: Bank stocks continue to be dogged by concerns that the U.S. economy is not yet healthy. Indeed, there are enough challenges in place from a regulatory and macro-economic perspective to retain pressure on bank stocks, so any rebound will likely be slow to build, perhaps over a few years, not a few quarters.

Action to Take -->
I'm not comfortable recommending any homebuilding stocks at this point, but there are several measures of housing data you need to track.

For example, the National Association of Home Builders (NAHB) releases its monthly survey of industry sentiment around the middle of every month. The index, which scored low last summer and fall, rose from 21 in December to 25 in January, and economists expect to see an even higher number ( in the 26 to 28 range) for February. As soon as the index appears to have reached a short-term peak, which a reading at 25 would imply, then housing stocks are likely to drop as investors seek to take profits.

If you were to invest in one bank stock, then it would be Citigroup. Indeed, I already have -- I bought 300 shares (worth roughly $9,000) in my $100,000 Real-Money Portfolio . To find out more about the stocks in my portfolio, go here to sign up and receive my latest ideas, which is completely free for a limited time only.


-- David Sterman

David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of C in one or more if its "real money" portfolios.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.


This article appears in: Investing , Investing Ideas

Referenced Stocks: BAC , C , JMP , WFC

David Sterman

David Sterman

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