Bank Stocks Sink On Cyprus Scare; How To Get Defensive

Morgan Stanley was leading the laggards among financial stocks in midday trading.

Shares of Morgan Stanley (MS) were down nearly 3%, while the Standard & Poor’s 500 Index and the Dow Jones Industrial Average were off less than 1%.��Citigroup (C) stock fell more than 2%.

Shares of JPMorgan (JPM) slid about �1% but shares of �Bank of America (BAC) were holding steady, down fractionally.

The market may have been waiting for an excuse to sell off. The preponderance of immediate risk tied to the Cyprus bailout,�to be met with a proposed tax on bank deposits, is in Europe. (See our Cyprus�blog coverage on the�revised Cypriot deposit-tax proposal, how the situation may pose an�emerging market investing opportunity and the rising price of gold.)

Citibank economics analysts in London say that while contagion risks in Europe are overrated, the risk of EU bank runs has clearly risen:

“But the unique features of the Cypriot situation should limit the �read through� to other cases in the euro area. Even when bank runs occur, the European Central Bank has the means to substitute for the funding lost from departed deposits. … Few other euro-area countries, however, are in the Cypriot position that almost all the senior unsecured creditors are depositors. None have bank balance sheets in excess of 700% of annual GDP. One also hopes that none have the reputational shadow of money laundering, tax avoidance and tax evasion hanging over them, as has been reported in the widely leaked report by the German secret service BND on the subject.* “

What does all this have to do with U.S. banks? Last week, financials were up 1.6% compared to a 0.7% rise in the S&P, with Bank of America and Wells Fargo (WFC) coming up winners in the Fed’s stress test and capital management pronouncements and JPMorgan on the opposite end. Financials as a group are up about 14% so far this year, outpacing the broader market by 400 basis points.

With that in mind, analysts at�Keefe, Bruyette & Woods attempt to define a defensive financials position in a note out this morning.

“What would a defensive position in financial stocks look like? We believe that it would largely include positions in stocks with limited correlation to bond yields, relatively low betas and under-performance year to date. We find that a basket of credit card stocks fit that description reasonably well, and would include American Express (AXP), Capital One Financial (COF), Discover Financial Services (DFS), Mastercard (MA), and Visa (V).”

Shares of Capital One were down nearly 1% Monday, while Amex stock was down 0.6%. Discover and Visa were unchanged and Mastercard was off fractionally.

KBW expects little change in Federal Reserve policy as the result of meetings Tuesday and Wednesday.

“Unless a more robust job market develops in the near term, Fed action is likely to keep the yield curve depressed and limit the further upside to many financial stocks. … For investors in financial stocks who are concerned that the job market is unlikely to spur near-term Fed action, a defensive posture is in order.”

*For more reading on the German secret service report that detailed how Russians laundering money in Cyprus would benefit from a bank bailout, this�Der Spiegel story in English, published last fall and flagged by Citi analyst�Willem Buiter�et al, is a great read.