Sovereign debt concerns have become a nagging issue for bank stocks, knocking the sector back sideways every time it gets momentum from improvements in credit costs, signs of loan demand or stirrings of dividend increases.
There was the pummeling the sector took in February, when the first serious alarm bells about Europe overshadowed the promising trends coming out of the bank industry's first-quarter earnings reports. Then in May the Greek fiscal crisis came to a head, unwinding the sharp rally staged in the intervening weeks.
By October investors were emboldened again, as they finally felt they could begin envisioning the return of loan growth and dividend income. But the pattern of one step forward, two steps back extended itself Monday as Ireland prepared to accept a bailout. The KBW Bank Index, which reached a three-month high of 48.68 on Nov. 5, fell 1.52% during Monday's session to close at 45.30, outpacing the 0.16% decline in the broader Standard & Poor's 500 index.
The fear isn't so much that the average U.S. bank will get burned by fiscal problems in Greece or Ireland, but that fiscal problems in Greece or Ireland may prove to be a gateway to broader trouble across Europe, a scenario that at some point could have bottom-line consequences for banks in the United States.
"Do we have any confidence that it ends right here in Ireland? We thought we had this thing ring-fenced with Greece six months ago and now Ireland pops up," said Phil Orlando, chief equity strategist at Federated Investors. "It's that kind of uncertainty which the market hates."
The chain reaction set off by the financial panic of 2008 remains for investors a poignant reminder of the power of contagion. But Bill Nichols, co-head of U.S. equity trading at Cantor Fitzgerald & Co., said there is a good chance investors' worst fears about the fiscal situation in Europe will not get realized.
"You could turn it around and say, 'Is the U.S. at risk from bad performance in California and New York?' Well, you can still tax people, you can still lay off government workers; you can have a combination of austerity and relief, and at the end of the day it could get resolved," he said.
But until the fundamental business of banking gets back on firmer ground, it will be difficult for investors to find a countervailing force when worst-case-scenario psychology overtakes the market.
"The banks are still working through their real estate portfolios. … They're net-interest-margining their way through problems, working through their foreclosure inventory. On the core business side, they're making money," Nichols said. "The question is, when will they make enough to get back to normal business, and people don't know the answer to that, which is why I think these stocks are moving kind of sideways."
For all of the uncertainty around bank stocks that has been settled in the past 15 months — from the apparent peak in credit costs to the passage of the final draft of the Dodd-Frank Act — the KBW Bank Index is back to where it had been in August 2009.
Fiscal woes in Ireland and southern Europe have not been the only drags on the sector. Investors have grappled on and off with how to size up the impact of foreclosure scandals, persistent weakness in employment and the housing market and slack demand for core bank products.
In a note this week to clients, Rochdale Securities analyst Richard Bove argued that the headwinds for bank stocks would be mitigated by a likely drop in loan losses and by efforts that banks have taken to strengthen their balance sheets.
Calling bank stocks "meaningfully undervalued," he wrote that "today, these companies are seeing loan problems peak and their balance sheets have a higher than normal amount of liquidity. This suggests that both earnings and stock prices will rise."
Orlando also is looking for an inflection point, citing the stabilization of credit costs, enhanced balance sheet strength and the prospect for higher dividends to return to the industry now that regulators appear ready to allow it.
"You almost get the feeling that you're right on the edge of watching the financial companies start to participate again" in a rally, Orlando said.
But he sees several issues holding back the sector: euro-zone exposure; uncertainty about the timing for a broad-based increase in loan demand; the ultimate impact of regulatory reform, in particular the new rules limiting proprietary trading; and the lingering questions about housing.
"Despite the fact that we believe that the housing market has bottomed, you are still lacking a robust employment cycle, and therefore you're still sitting here flatlined," Orlando said. Tax credits that the Obama administration offered to home buyers moved up the timing of purchases but "did nothing to stimulate organic housing demand." The credit and other government relief programs have created "mini boom-and-bust cycles," Orlando added. "We're in the process of sleeping off that second hangover now."
With that kind of backdrop, it's easy for a bull on bank stocks to lose heart in this environment.
"For a person who's been recommending particularly the larger-cap names in the index, it's been disappointing," said Frederick Cannon, co-director of research and chief equity strategist at KBW Inc.'s Keefe, Bruyette & Woods Inc. "It has seemed like one thing after another, and the good news doesn't seem to be able to be sustained in the stocks."
Every time a key source of "overhang" on the group disappears — when the specifics of regulatory reform finally got hammered out over the summer, for example — another source emerges, Cannon said. "Ireland has a very limited direct effect on U.S. banks, and the dividend issue was fundamental good news that I thought would kind of override some of these issues. … We got a little lift out of that, but not much."