I have investigated around 30 EU banks for a research paper that I will come back to on this blog after it is published (soon I hope). The paper deals with something completely different than algorithmic trading but a side-result of the paper is that I found that over the last nine months the average European bank’s total asset value (financed with around 90% debt) actually fell substantially more than its stock value! This is rather odd in a highly leveraged firm such as a bank and not something I have really observed before (2004-2010). The trader in me (of course) reacted to this!! One driver behind an increased stock price in the light of a fall in the value of assets is of course that the volatility of the assets perhaps have increased. Remember, equity in a firm is like a call-option on the firm’s assets and an increase in the volatility of the underlying leads to an increase in the option price (ceteris paribus). I have not observed such an increase in the asset volatility over the last year, though.
On average, the asset value fell 12% and the stock value fell 8%. Now, how did I estimate the asset value? That is the crucial point here and if I screwed up here then my trading signal is completely useless. The problem is that the asset value is not observable and that is what makes the suggested trade interesting as well as risky. I have not had time to look deeper into the balance sheets and quarterly reports of several EU banks and it is also possible that some kind of outlier drives the result so my advice therefore has to be taken with a dose of skepticism. In any case, I believe that either the asset value will recover or the stock price will fall for the typical bank in Europe over the next couple of months. And if you already, as me, are sceptical about the health of the european banks you could try to focus on asset values when chosing bank stock to trade.
Anyway, my n-month verdict for the EU banking sector is underperform!