Global investment banks had a remarkable start to the year. But the rally has gone far enough. Shares in Goldman Sachs Group, Morgan Stanley and J.P. Morgan Chase have doubled from their lows, while European wholesale banks also are up sharply. Shares in Barclays, for instance, have tripled since early March.
Yet big questions remain over their future business models, making further price rises hard to justify.
Sure, the banks were due a rally after they used their 2008 results to finally mark toxic exposures to realistic prices. That relief turned to excitement as it became clear the industry was enjoying a substantial profit recovery in the first quarter.
Investors also will have rightly noted that policy makers on both sides of the Atlantic are making it abundantly clear they are standing behind the industry.
But if the bank's survival now looks assured, the challenge for investors is to figure out what multiple of book value to pay for them -- and what the size of that book might be. That is much less clear-cut.
At the peak of the boom, the average investment banks were earning returns on equity of about 25%, well above the then-cost of equity of 10%, while book value was growing fast. That enabled the banks to trade on high multiples of book. But these days, it is far from clear banks will be able to earn returns over their cost of equity, which is now around 13%, while book value may even fall.
True, the first quarter has been encouraging, with most banks reporting a boom in certain product areas such as foreign exchange, swaps, fixed-income trading and commodities.
And with so many competitors gone margins are up anywhere from 50% to 300%, according to Morgan Stanley research. But not all areas are performing well: Equities and mergers and acquisitions are weak.
Besides, the positive impact of higher margins is likely to be at least partially offset by deleveraging. The 15 largest investment banks have so far shrunk their balance sheets by $3.6 trillion and are likely to shed a further $2 trillion in 2009, equivalent to 13% of their assets, according to Morgan Stanley.
The European wholesale banks in particular still look very highly leveraged, with average common equity of 2.6% of tangible assets, well below the 4% that appears to be becoming the de facto industry standard.
The banks also face significant regulatory risk as new capital and liquidity requirements and new rules on compensation take effect.
Where does that leave investors? Morgan Stanley assumes average industry returns hit 13% -- although long-term industry winners such as Barclays, Credit Suisse and Deutsche Bank with strong positions in the new hot areas of flow trading should do better -- while growth in book value is subdued.
With returns in line with cost of equity, valuations in excess of book value look hard to justify. Yet U.S. investment banks already are trading well above book value, while the average European wholesale bank trades on 1.1 times average 2009 tangible book value, based on Morgan Stanley forecasts.
To buy into the investment banks from here is to bet on a lot of cards falling into place for the industry: no more credit losses, a rapid economic recovery and an easy ride from regulators. That is surely asking too much.