Above the noise: Despite the multiples, banks aren't attractive

In the last couple of months, when I have been interviewed by TV or a newspaper, the same question has been asked of me. 'Would you invest in banks at this point?' I could just say no, but that doesn't make for good press. The longer answer lies in the deleveraging process we're currently going through.

The misunderstanding of P/E and P/B in a deleveraging

Most bullish strategists and analysts on banks argue a P/E of 11.7 and a P/B of 1.18 makes US banks attractive to buy as the US economy is growing. They also point out bank stocks are still 50 percent below the peak (see chart below) and there is room for upside.

For European banks the argument is the same albeit the P/E is 9.9 and P/B is 0.6. Note:  P/E is only meaningful when you calculate it on the profitable members of the bank index, so basically it tells you that the European banking industry as a whole is in dire straits.

This argument makes sense in a 'normal' economy but it's not; we're going through deleveraging, meaning asset prices are not growing as fast, the economy is growing below trend and there is a higher probability of setbacks in any recovery. Therefore the earnings potential is way lower for banks and as such the future stock price potential is lower.

Another major driver behind lower earnings power is the increase in regulatory requirements. This force should not be underestimated and has always happened following a banking crisis. With three scandals already this year (MF Global, The London Whale and Barclays' LIBOR-fixing) the regulatory intensity should not be expected to retreat anytime soon.

There's an argument that banks aren't needed in a portfolio, but if you insist, which ones?

US vs. European banks

The follow up question from journalists is always: 'What about US vs. European banks?' Well, European banks are a no-brainer - stay away.

Regarding US banks, I normally answer that we are a bit more positive and say there are selective opportunities, which is true. On average though, the stock price potential is by no means spectacular. Again, deleveraging is to blame.

As an example, let's take a look at the only other meaningful deleveraging period in modern economic history: the Great Depression in the 1930s. US banking sector profits from 1929-1940 were fairly stable in terms of percentage of GDP. Banks' profits declined "only" 40 percent - in line with nominal GDP. Strikingly, the overall sector remained profitable throughout the crisis.

Another and more important observations in today's context is the fact that profits grew very slowly in the years following the bottom in 1934. According to the book, The Partnership: The Making of Goldman Sachs, Goldman Sachs first became consistently profitable on a year-to-year basis after World War II. Now Goldman Sachs was not a commercial bank but it still gives you an idea about the profound implications a deleveraging and economic growth below trend have on commercial and investment banks.

Source: Banking during the Great Depression: The good news

Given the developed world's private sector is still experiencing deveraging, increasing regulatory requirements and over-debted sovereigns, the probability is quite high that banks will perform poorly in aggregate terms. US banks will perform better than European banks because the hardest effects of the deleveraging has already worked itself through many parts of the US system and the economy is growing somewhat. The story is quite different for European banks.

Why are European banks a black box for investors?

First, let us dismantle a myth about European vs US banks. On the surface, it looks like European banks are way more leveraged - and Deutsche Bank is often the poster child. But this is misleading because US and European banks do ot comply to the same Basel rules. If you compare US and European banks on the future Basel 3 rules then the leverage is very similar.

Second, funding structure. US banks have around 80 percent loan-to-deposit ratio where it is 110 percent in Europe - leading to a deposit funding gap of EUR 1.3 trillion. This European gap is funded in the wholesale markets and herein lies the potential trigger for tail risk and, also, why the ECB initiated the LTRO programme. Nobody wanted to fund European banks in the wholesale market.

Why are the funding structures so different? Mainly due to the regulatory response in the US following the banking crises in the 1930s and 1980s. Both events led to US banks having less mortgage exposure on their balance sheets (that went to Fannie Mae and Freddie Mac - essentially the US government) and more US companies funded themselves directly in capital markets through corporate bonds. Europe's banks are more linked to the mortgage market and corporate loans - a weak part of the chain in a deleveraging, especially when the economy is contracting.

Given the ongoing deleveraging, structural issues in Europe, increasing regulatory requirements and the question marks over what happens when the LTROs end, it seems European banks will be a bad investment choice.