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European Banks: Should Investors Continue to Dance While the Music Is Playing?

For those who don't need exposure, it may be time to take profits.

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European bank stocks have outperformed the market significantly since European Central Bank president Mario Draghi announced in July 2012 that he would do "whatever it takes" to save the euro. As markets absorbed this statement, the discount associated with the possibility of a eurozone breakup faded. In the following nine months, the shares of European banks shot up more than 47% compared with just 16% for the S&P 500. This impressive performance has led many investors to wonder whether there is still upside in European bank shares, or whether markets have gotten ahead of themselves. We argue that it is the latter that is true and that European banks are now, on average, fairly valued. We think their stock prices are built on the current calm in the market, which we see as mere complacency. We argue that significant risks to Europe's economic outlook remain, and that European banks will not return to their former profitability and instead will struggle to earn their costs of equity. Moreover, we think material risks remain to the market's generally sanguine view of European banks, as evidenced by Cyprus' recent deposit grab, and that at an average of 1.0 times tangible book, most European shares face more downside than upside.

The Key Question: Will the Rally Continue?
The rally in European bank share prices has piqued the interest of many investors, who are now asking whether the outperformance is likely to continue, and whether dips--like the one associated with the recent Cyprus deposit tax brouhaha--should be viewed as a buying opportunity. We assert that the shares of European banks are, on average, fully valued and that the current prices do not offer investors a sufficient margin of safety, given the still-large risks facing the European economy and the risk of additional shocks to the banking system. We think the recent events in Cyprus highlight the risk of unexpected negative shocks and demonstrate that the rules in Europe are being written as we go along.

Erin Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.