Why the Bank Sector Is Rebounding

Though considered market poison just a few months ago, bank stocks have roared back as investors have chosen to look past the debt crisis in Europe and instead focus on whether the industry is finally ready to stage a comeback.Financials performed worst of the 10 Standard & Poor's 500(SPX) sectors in 2011, with banks in particular tumbling nearly 25 percent as measured by the KBW Bank Index.But the story has been different since Wall Street turned the page on the new year.The S&P 500 financials -- a sector that also includes insurers, credit card companies and other related businesses -- is the second-best performer this year, with a 2.8% gain, while the KBW index has surged 8.5%.Bank of America(BAC), trading below $5 a share as recently as Dec. 19, has surged 37% in three weeks.Perhaps no other group has benefited as much from decoupling -- the market's latest investing meme that refers to the way U.S. markets finally have stopped reacting to every tremor coming out of Europe and now are focused more on domestic issues.Investors may now be ready to believe that three years of aggressive government assistance, capital hoarding and earnings growth are making the banks attractive, regardless of the contagion risk that Europe's sovereign debt crisis poses."The stocks are attractive because investors have failed to grasp fully what has happened and the stock prices have continued to fall. Thus, as the fundamentals for the industry have improved the marketplace has not reflected the improvement," said Dick Bove, the outspoken bank analyst at Rochdale Securities. "A classic time to buy these stocks is here and has been in my view for months."While Bove has railed against government regulation overreach and preached the virtues of bank stocks, the shares themselves had not responded.Wall Street worried that should sovereign debt defaults in Europe and elsewhere trigger European bank failures, the fallout inevitably would impact U.S. banks.All of the unknowns in Europe remain firmly in place. Yet American investors have been gobbling up bank stocks in large numbers.

"Bank investors have steadfastly ignored every positive development in this industry in their passion to sell these issues," Bove said. "The industry's problems start with management credibility. Investors simply do not believe anything that bank managements say about their companies."

The primary reason for the doubts is that investors have been burned before by banks.They obediently bought the stocks prior to the financial panic unfolding in 2008, believing the narrative that the industry had sufficient protections against the subprime mortgage industry collapse.Since then, banks have struggled with a variety of issues, from regulatory fallout related to excessive risk-taking that led to the crisis, to the effect the stumbling economy has had on loan demand and profits.At least one issue -- mortgage putbacks, or the requirements that originating banks buy back mortgages from the current holders due to fraud -- appears to be grinding toward a solution.While acknowledging that the total cost to the industry remains hard to determine, Bernstein Research senior analyst John E. McDonald said the damage should be manageable."Despite uncertainty around the cost of putbacks, we continue to see long-term value in the stocks as the issue appears manageable using reasonable loss rates in the context of banks' capital positions," McDonald told clients.As for banks best setup to withstand putbacks -- once considered a near-apocalyptic event for the industry -- McDonald lists JPMorgan Chase(JPM) and Citigroup(C) in the large-cap space, and Capital One(COF) and SunTrust(STI) in mid-caps.But small-caps also are drawing interest, particularly because they offer less exposure to Europe because they do most of their business domestically.Credit Suisse small-cap analyst Lori Calvasina recently raised her forecast for financials, citing four reasons: the tendency to outperform economic growth; a better climate for mergers and acquisitions; the tendency by many managers to hold fewer stocks in the sector than normal, and improved investor sentiment."This sector is clearly back on small cap investors' radars heading into 2012," Calvasina said. "This is especially true for banks, the one industry we have received the most questions on over the past few months from core, growth, and value managers alike. While we still see several key problems for this sector as a whole, we are noticing improvement in a number of areas, and are upgrading to a modest overweight."

Another issue that may not be as much on investors' radar involves deferred tax assets, or DTAs, which are held on balance sheets to help pay for future tax issues. Industry capital weakness made the DTA issue a negative for the industry that may be wearing off.

"Throughout the economic downturn, elevated losses forced a number of institutions to establish valuation allowances against their deferred tax assets," said John Barber, analyst at Keefe, Bruyette & Woods. "While this event was meaningful for a number of institutions when it occurred, we believe select bank stocks are well positioned to recapture either a portion or all of their deferred tax assets in 2012."Barber's best plays in that regard are Heritage Commerce(HTBK) and Pinnacle Financial Partners(PNFP), and advises investors also to watch Citizens Republic Bancorp(CRBC), West Coast Bancorp(WCBO), United Community Banks(UCBI), Mercantile Bank(MBWM) and CoBiz Financial(COBZ).For bank bulls, the convergent factors are setting up for a reversal of fortune."So, the required macro metrics are in place. The required micro metrics are in place," Rochdale's Bove said. "The result should be increased earnings. They are in fact in place also." >To order reprints of this article, click here: Reprints