Bank Stocks Declined 20%, and then Recovered As Forecast by Chinese Currency (CNY), But are Again at Risk

1. Bank Stocks Declined 20%, and then Recovered
As Forecast by Chinese Currency (CNY), But are
Again at Risk
Bank stocks fell 20% from year end 2015 to mid-February following the
sharp decline relative to USD in Chinese currency (CNY) from early
November to early January 2016 (see Chart I below).
Bank stock valuations to book value were relatively stable in recent years;
selling at 1 times book value with ROE equal to COE and rising to 2 times
book value with a spread of 10% between ROE and COE (see solid line on
Chart II). The correction in bank stocks to February lows reduced
valuations to 0.80 times book value with ROE equal to COE and 1.8 times
book value at a 10.0% spread between ROE and COE (see dotted line on
Chart II).

2. The devaluation of the Chinese currency from 6.34 to the dollar in November, 2015
to 6.60 in early January, 2016 created fear, not economic fundamentals, which
sparked the sell-off in China equities, which then spread to global markets and the
oil price slide.
China is in the midst of a shift from an economy reliant on exports and an
infrastructure building boom to one based on economic consumption. Many
observers point to the confusion over Beijing’s currency management and lack of
transparency over the policy road map ahead as the key problem.
Bank stocks recovered from February 11th lows, as forecasted with the 30-day lead
of CNY (see arrows on Chart I). However, bank stocks failed to reach 2015 peak
levels and valuations remained near their lows (see Chart II). A devaluation of the
Chinese currency to the dollar (CNY rising to 6.60 or weaker) would forecast in
June a further decline in bank stocks, T-Note yields, and global equities.

3. Chart I

4. ROE Compared to COE Still the Best Indicator of Value
Investors and analysts measure the performance of bank holding companies
by comparing return on equity (ROE) against the cost of equity capital (COE).
If the ROE is higher than the COE, management is creating value. ROE less
than COE, management destroys value. Value is measured by stock price to
book value, i.e. equity market capitalization to book value of common stock
(See Chart II “Bank Valuations for Large Bank Holding Companies”).
But some critics say the method is flawed, one side (ROE) or the other (COE).
Banks, as an example, have insisted returns should be measured on tangible
equity, excluding goodwill and other intangible assets from the calculation,
generating a higher ROE, but lower tangible book value. IDC Financial
Publishing, Inc. (IDCFP) uses a four quarter nominal ROE, as reported,
ending March 31, 2016.

5. A second side of the equation is cost of capital. Some analysts use a long
standing rule of thumb of 10% cost of capital. IDCFP, however, uses the long term
U.S. treasury yield plus one-half of that yield, adjusted for bank specific risk. In
today’s market, a long bond U.S. Treasury yield on 03/31/2016 was 2.6%, and the
average cost of equity capital for the large bank holding companies was 4.3%,
ranging from 3.9% for KeyCorp (KEY) to 5.5% for Bank of America Corp (BAC).
The tight fit of the Market Capitalization/Book Common Equity compared to
IDCFP’s ROE less COE for large banks in Chart II demonstrates the usefulness
of a cost of equity capital tied to the long term U.S. Treasury yield to determine
the price to book value.
The value of increasing a positive ROE – COE spread by 100 basis points adds
an estimated 10.0 basis points to the market capitalization to equity ratio. High
valuations of price to book relative to the ROE-COE spread for WFC and USB
responded well to bank stock volatility as valuations were maintained. The low
valuations of BAC, C, and RF with narrow ROE-COE spreads were more
vulnerable and illustrate specific risks, not explained by the cost of equity capital
based on interest rates or normal risk evaluation.

6. Chart II
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