After a strong rally from March lows (+90%), we are taking a step back to review our banking stock calls. At 1.4x 2009E P/BV, banks are priced at historical averages. We think share prices have priced in an earnings recovery scenario and potential reversal of paper losses from investment books. We downgrade DBS and UOB to HOLD; we maintain our HOLD rating on OCBC. Our fair value multiples are left unchanged and are based on mid-cycle P/BV valuation. However our target prices have been raised slightly after rolling over our base year to 2010.

Unlike the powerful rally seen in the aftermath of the Asian Financial Crisis (which rose to 2.7x from 0.4x P/BV in 15 months) we think further re-rating will be gradual. This time, the world economy is fraught with long-standing imbalances and a weaker financial system. As a result, it could take the same recovery route as the one that followed the SARS outbreak: 3.5 years to deliver a convincing breakout (from mid-cycle levels) after three years of solid annual economic growth averaging 8%!

Assuming bank stocks were to re-rate to one standard deviation (SD) above their historical averages, the price upside is a modest 10% for UOB and OCBC, but a larger 16% for DBS. Valuation has only breached this level twice since 1995. Our analysis suggests that the market has already factored in assumptions that reflect reasonably strong GDP growth of 5% pa in 2010-11 compared with our forecast of 2.3% in 2010 and 3.6% in 2011.

Barring another round of global shocks, a retest of previous lows is remote, in our view. Being one of the most open economies in the world, Singapore’s fortunes will remain hostage to external factors. As such, the global economic outlook will continue to dictate the performance of Singapore banks. Trading at mid-cycle valuation, banks do not look attractive and the initial re-rating may have run its course, in our view. We would await a pullback to regain entry. UOB remains our top sector pick for its more exciting ROE profile.