Will high-flying bank stocks curse the market?

PORTFOLIO POINT: If events of the past six years are any guide, bank share overshooting targets will herald a market retreat.
To most investors, it must seem an odd concept that the Australian stockmarket has already run into valuation constraints after three weeks of rallying have lifted it 16% off its lows of early March, but that's exactly what has happened.

Commentators elsewhere will tell you profit takers have moved in after the strong move upwards, or that technical resistance levels are looming, or something else, but when I look at the stockmarket I see share prices, especially bank share prices, having moved beyond 12-month target prices.

Here’s a simple indicator: Keep a close eye on the gap between share prices for banks and their 12-month target prices. If share prices move beyond their target prices this indicates investors have pushed up share prices too far. A retreat is likely to follow.

What makes the indicator even more interesting is that it doesn't simply measure over-valuation for the banking sector but for the stockmarket as a whole. In the past six years – without exception – every time bank shares have moved up too far it has been followed by a general stockmarket retreat, not just by the banks.

Because individual price targets, set by one analyst or by one stockbroker, can vary significantly, I use average price targets calculated on the basis of 10 major experts in the Australian stockmarket.

As such, investors might want to know that the rally from August to early November 2007 had pushed bank shares well beyond consensus price targets. Unfortunately, for investors who would have liked to see the rally in March this year at least extend into a fourth consecutive week of everyday rising share prices, we are now facing a similar situation: all bank stocks have moved well beyond their average price targets and are facing a general retreat.

Where to from here? The first thing to know is that there has been a swift reversal in the balance between recommendation upgrades and downgrades by our leading 10 stockbrokers and investment experts.

Throughout the results season in February, securities analysts continued to issue more recommendation upgrades than downgrades. That was part of the good news in February. However, ever since this rally extended beyond its first week, the balance has moved towards more downgrades than upgrades.

And last week, as the S&P/ASX 200 index moved closer towards what many technical chartists pinpoint as the next level of technical resistance, at 3780, the amount of recommendation downgrades accelerated. As at Wednesday (April 1), the balance has exploded to 35 downgrades versus only 11 upgrades while the index was trading at 3590.

What's more, the composition of existing Buy/Hold/Sell recommendations has changed. For the first time since the start of the bear market in 2007, the total number of Buy ratings by the 10 stockbrokers and investment advisers has now fallen below the total number of Neutral/Hold recommendations. The difference is not huge, but the switch might mark an important event.

Second, the negative gap between consensus price targets and bank share prices is too big to ignore. On Friday all the Big Four were trading at a premium to their share price target – Commonwealth Bank (CBA) at more than 9% the highest, and National Australia Bank (NAB) at 5% the lowest.

An overall improved sentiment towards banks worldwide had lured investors back into buying bank shares. As bank shares in Australia moved beyond their targets, stockbrokers might be considering raising their targets on the back of the overall improved market sentiment. Recently stockbroking analysts at Citi have gone ahead and raised their targets. So far, however, nobody else has followed suit.

In fact, some banks are being downgraded: ANZ Bank has received two recommendation downgrades, as did Macquarie Group (MQG).

Does this mean most banking analysts in Australia have now collectively dismissed the idea that Australian bank shares deserve to trade at higher market multiples? Perhaps it simply means most analysts prefer to wait for further indications things are really improving for Australian banks before they commit to higher forecasts, valuations and price targets.

From late April onwards, most Australian banks will update investors on how they've performed in the six months to March. In light of all of the above, those public releases might prove to be more important than ever.

In the meantime, the absence of any other stockbroker lifting its 12-month target prices for Australian banks does increase the risk for further pullbacks as investors might get nervous about whether banks are still undervalued, fairly valued or even overvalued at beyond-target price levels.

Those who've kept a close watch on share price movements over the past week might have noticed CommBank shares underperformed the other banks from the moment the shares hit $35; more than 9% above the average target and equal to the new target set by Citi analysts. Maybe this was a signal that investors agree with the analysts that the market leader does not yet deserve to trade at a price-earnings ratio above 12 for the time being?

Note: Stockbrokers' price targets are usually set for a 12-month horizon. This analysis covers price targets in the market as at March 30, 2009).

Rudi Filapek-Vandyck is editor of FN Arena, an online news and analysis service.