Banks Now Overpriced – What Does That Mean?

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

By Rudi Filapek-Vandyck, Editor FNArena

The old adage for share market investors that following the herd does not equal better long term returns has again sprung to the fore in the weeks past as share prices for Australian banks continue to rally from their temporary lull in June.

As some among you may remember, at the beginning of the year I firmly rejected opinions expressed elsewhere that banks were best avoided.

Instead I argued solid, reliable and growing dividends, albeit not at the same speed as once was common for the sector, would retain their attraction in an overall environment of "risk-on/risk-off" switches and a global context that makes reliable, growing profits something of a rarity. This applied in particular to Australia where profit growth has remained largely absent since 2009.

Little did I know at the time that a buying frenzy would take off in June and push shares of the market leader, CommBank ((CBA)), within grasp of its all-time high from early November 2007 when shares peaked at $61 per share. As the Big Four in Australia tend to move in unison, investors owning shares in Westpac ((WBC)), ANZ Bank ((ANZ)) and National Australia Bank ((NAB)) have done well too; much better than the index or (most) small and larger miners and energy producers.

As share prices moved ever so higher, so did overall interest from investors and from market commentators. Next thing you know, the banks are looking good on technical price charts and onwards the carrousel goes.

Banks in Australia have carried my personal interest ever since I observed the close relationship between investor risk appetite, bank share prices becoming fundamentally overvalued and subsequent share market corrections. That was many years ago. It was this basic observation that inspired the development of The Icarus Signal on the FNArena website. And it was this same observation that has played a major role in my past warnings ahead of major share market corrections: April 2011, April 2010, November 2007, et cetera.

Earlier this year, when the share market "peaked" in early May at 4435.90 for the ASX200, bank share prices had again surged above consensus price targets, which led to yet another of my overvaluation-warnings. Soon after equities pulled back, though the "correction" didn't last long. Here we are in mid-August and share prices for the major banks have rallied well above the levels that led to the warning in May. At least, this is the case for CBA and for Westpac. Shares in ANZ and NAB are back around the same level as four months ago.

The chart below shows the share price for ANZ Bank this year. Even without my commentary, one can clearly see how a peak was formed in April-May and how we are now back to those same levels. Note the consensus price target (shown as coloured background) moved a bit higher in May, but only a bit.

The same pattern characterises share price movements for the Big Four in 2012.

This automatically leads us to the question: are we about to experience another share market sell-off?

Before we tackle that issue, let's stick with the banks for a moment (I promise we will get back to the broader question).

When share prices for banks reach above stockbrokers' price targets, investors need to ask one key question: what are the chances the market is moving ahead of analysts' expectations? In May 2009, the same situation occurred, only at that time analysts still had to catch up with better fortunes ahead and thus banks' share prices simply kept on rallying much higher, and deservedly so.

Stockbroking analysts at major brokerages and investment bank have taken another look at banks recently and without exception not one has come to the conclusion that a repeat of 2009 is about to play out. In other words: banks in Australia continue to operate under circumstances that allow for only low growth in profits and dividends. How low exactly present and future growth will turn out is something we will find out in the weeks and months ahead, but it seems that a return to double digits, or even high single digits, remains a low odds outcome right now.

From a fundamental perspective, this means any lift in valuations will remain moderate, at best. Which is why Model Portfolios are being reshuffled towards a lesser weighting for banks and why the first broker downgrades have started to roll in.

Investors who are yet to jump on board, while harbouring a healthy appetite for yield, may take some guidance from what has happened to the Telstra ((TLS)) share price in recent sessions. After surging to $4.07 last week, the share price is now down close to 8% with the losses exceeding the potential dividend yield on offer (circa 7.5% ff at $3.75).

There is one other warning in all of this: every time share prices for CBA, Westpac and ANZ Bank look "fully priced", stockbrokers and investors tend to shift their focus to NAB, the perpetual laggard in the sector. This, however, is more likely to turn into a costly error of judgment as NAB shares, while looking reasonably valued at face value, will still be pushed lower when the other three retreat to lower price levels. Note that my prediction has history on its side.

Note to everyone: playing the reversion to the mean game is not a guaranteed recipe for success. Sometimes there is a very good reason why the principle won't work. One day NAB will get rid of its troublesome UK assets and the gate will be open to a valuation in line with its peers in Australia. Until then a relative discount will remain in place, and warranted.

Which brings us to the question we asked prior: does an overvalued Australian banking sector yet again warn of a broader sell-off?

I note that, historically, whenever bank shares slid back from too hot to handle price levels, this has always translated into a "correction" for the share market in general. This is because banks moved in line with risk appetite and investor optimism. Today this may not automatically be the case as one of the reasons as to why banks have rallied so hard since June is because of an extreme focus on solid yields, the opposite of elevated risk appetite. Thus it may well be that this time is different and risk appetite rising may mean banks' share prices could well be left behind as the more typical cyclicals return to investors' favour.

For investors, how to best treat this information should be determined by the prices at which they purchased shares and what their expectations are for returns in the years ahead. As I pointed out earlier this year, shareholders in CBA and ANZ had managed to recoup all losses since November 2007, largely thanks to consistently growing, solid dividend payments. After the recent rally, shareholders in Westpac are now in the same boat. For shareholders in NAB there will be no similar relief in the foreseeable future.

Contrary to the investment case for NAB, a switch out of banks into riskier miners and energy companies makes sense from a relative point of view as the valuation gap between "defensives" and "risk" had stretched to seldom witnessed extremes – see chart below (thanks to UBS).

There is also one key similarity with the case for NAB shares: for the gap to ultimately close on a more sustainable basis, there will eventually need to be a fundamental reason which goes far beyond the next round of central banks' stimulus. After all, shares in Woodside Petroleum ((WPL)) have since mid-2006 on three occasions rallied by 50% or more and yet here we are today and Woodside shares are in essence unchanged from mid-2006, translating into a dismal return for investors who bought six years ago and are still on today's register.
 

Note that the first week of Australian profit reports has generated three standout earnings reports with future profit expectations rising (against the wider trend in the Australian market). Share prices for all three -Computershare ((CPU)), ResMed ((RMD)) and Flexigroup ((FXL))- have outperformed in response.

(This story was originally written on Monday, 13 August 2012. It was published on the day in the form of an email to paying subscribers).

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