Thursday, January 24, 2008

Bank Stocks: Still Early To Declare We Are At The Bottom - Citigroup

4Q earnings confirmed credit pressures continue to build, NIM pressure was more than expected, and capital constraints became more pronounced. Despite this, bank stocks were up 12% (vs 0.4% for S&P500), with the catalyst being the Fed's emergency 75 bp cut which fueled short covering . This rally could continue into next week's Fed meeting, but after that, the firm sees selling pressure emerging as incremental data points on credit likely to increase market concerns.

In prior bank stock troughs, there was very clear evidence the banks bottom when the Fed decides to aggressively cut rates, normally leading to steeper curve. This time is different in that curve is inverted and moderately steepens as '08 progresses, which is much different than steep curve environment in prior easing cycles. Overall, the firm ests benefit from lower rates is relatively modest and not enough to offset credit.

While aggressive Fed is one key driver to finding a bottom for stocks, the other is a slowing in the growth rate of NPAs, and they believe we are still early in the credit cycle. Firm believes the stocks partially embed very weak consumer, but are not taking into account the risks regarding CRE and corporate and thus buying banks here is a bet that problems will not bleed into CRE and

The big question the past two days has been who is the incremental buyer behind the huge rally in the bank stocks. Citi believes the buying was driven mostly by short covering by hedge funds, but they believe the later stages of the rally were marked by long only buyers who did not want to miss the bottom. While this is hard to prove, an analysis which sorts the 2-day performance for the bank vs the relative days to cover (short interest divided by average daily volume), and while not perfect they did see a pretty strong correlation behind the top performers and most heavily shorted stocks. Assuming it is mostly short covering, they would expect the shorts to start to come in after the Fed meeting next week and re-establish shorts ('sell on the news') as a strong case can be made that the credit headwinds are getting stronger and there is likely to be more negative data points in 1Q (which is also a seasonally weak quarter) firm's view is bank stocks are likely to retrace many of these gains over the next couple months.

Notablecalls: The news out of Societe Generale may also help to stall the current rally in bank stocks. So, despite the current early bullish tone of the mkt, I would not be surprised to see a fade.

Watch Citigroup (NYSE:C) for indication.

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