Investors caught out by banking rally

It has been the most extraordinary and brutish rally. Since hitting their lows three weeks ago on January 9, UniCredit’s shares have surged by almost 70 per cent.

Other European banks have seen rises nearly as spectacular with Société Générale, Royal Bank of Scotland and Intesa Sanpaolo all up about 40 per cent.

But most investors have been caught on the wrong side of the trade. European bank stocks have been called “uninvestable” by some. And, along with retailers, they are the most shorted stocks, according to fund manager surveys.

Yet as investors and analysts catch their breath, the question is whether investors should chase the rally or instead maintain their pessimism?

The main reason for the rebound is clear: the European Central Bank’s provision of three-year loans to banks, known as the Long Term Refinancing Operation, has eased fears of an imminent bank failure.

“There was an extreme bearishness ... The LTRO is really making it inconceivable that any of the European banks will go under. That has had a significant calming influence,” says Andreas Utermann, chief investment officer of RCM, the equity fund manager belonging to Germany’s Allianz.

The removal of this extreme risk has left some investors exposed because of the general bearishness around banks and the fact that so many were underweight.

“Investors have been caught out by this move because expectations were so low and positioning so negative,” says Thomas Moore, an equity fund manager and bank analyst at Standard Life Investments in Edinburgh. “Some investors are clearly nervous because they are short or underweight.”

Nick Nelson, an equity strategist at UBS, says one of the biggest underweights for hedge funds at the start of the year was on banks. But while the outlook has improved somewhat, he remains hesitant to endorse the entire sector.

“A lot of the darkest fears that were there have gone because of the LTRO. But banks are an extreme bet. They have gone from being perceived as uninvestable to being selectively investable,” he says, pointing to his bank’s continuing bearishness on, for instance, Spanish lenders.

Recent data may have surprised on the upside in Europe as well as the US. But Europe remains on course for a recession and that is likely to lead to a rise in bad loans, Mr Nelson believes.

On the other hand, the relative normalisation of the government bond yield curve in Italy and Spain means banks can earn money from exploiting the difference between short and long-term interest rates.

That in turn has raised fears among some people over whether some banks have just doubled up on their sovereign debt bets.

Many investors remain sceptical about whether the rally can go further. The troubles of the banking sector are well known, from the risks of upcoming regulation, such as the Basel III capital rules, to continued worries about the sovereign debt crisis.

Many investors fret that balance sheets are still opaque and difficult to read, justifying valuations of under half book value.

Mr Utermann argues investors should be cautious about chasing the rally further. “If you took part in it there is a case to lighten things a little. You might have gone from 2 per cent exposure to 3 or 4 per cent. And if you have missed it then, frankly, this is not the time to buy.”

He adds that how the sovereign debt crisis is resolved remains crucial for banks, putting investors in a tricky situation.

“If any of the European peripheral countries go down in an uncontrolled fashion then these banks will be in trouble. This needs to be discounted, which makes valuations fiendishly difficult,” he adds.

Others disagree. Mr Moore says investors ignored the power of the LTRO for a month and even now there is a lot of negative feeling about banks. “There is a lot of pessimism out there. It suggests there is still scope for valuations to re-rate,” he adds.

Similarly, credit analysts at Citi say: “The fact that investors are so reluctant to commit to the rally and the effect of the LTROs makes it all the more likely that it continues for considerably longer than people envisage – or indeed, by more than is warranted by fundamentals.”

Take a step back from the action of the past three weeks and the picture looks bleak.

Société Générale of France is still down about 50 per cent from the start of 2011 while UniCredit is 70 per cent lower.

The Italian bank has undoubtedly benefited in recent weeks from the lifting of worries about its rights issue. But for all of its explosive gains, UniCredit is still down by more than 10 per cent this year.

The chief executive of one of Europe’s biggest insurers – and therefore investors – says: “It is a cautionary tale. Investors need to have very strong nerves to go into European banks at the moment.”