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It’s been a remarkable turn of sentiment for banks since early last year, when we wrote “Everyone Hates the Banks” in our February 2016 edition of The Turnaround Letter. At the time, not only was the stock market selling off, but bank stocks were falling even faster. Investors were worried that a weakening economy would delay the Fed’s interest rate hikes and increase loan losses, particularly from the energy sector – both of which would crimp banks’ already tepid earnings outlook.
We certainly didn’t foresee the economic upturn that started in mid-2016 nor the November presidential election outcome. All we knew was that bank stocks had bargain-basement valuations, relatively solid balance sheets and attractive dividend yields, all within a much-improved banking system. These traits made the banks very interesting as investments.
Both the economic upturn and the election were very favorable to banks. After continued price volatility in the first half of 2016, the KBW Bank Index surged 18% in the months ahead of the election. Following the election, bank stocks surged another 32% to their peak on March 1, 2017, a total gain of over 55% from their early 2016 level.
Expectations for a healthier economy (more loan growth, lower defaults), rising interest rates (better spread on loans) and a more favorable economic and regulatory climate (more growth, lower costs) provided the fuel for the sharp change in investor sentiment and share prices. Our highlighted selection of bank stocks produced similarly strong gains, rising 56%, more than twice the gain in the S&P500 index:
With the strong gains, and a recent 8% decline from their March 1st peak, what do we think about bank stocks today?
Some of the expectations that fueled the rally (healthier economy, higher interest rates, more favorable regulatory climate) are transitioning into reality. This is boosting confidence in banks’ future earnings power. Consensus estimates for 2018 and 2019 earnings are considerably higher than they were a year ago. Also, the friendlier regulatory environment could allow banks, with their strong balance sheets, to return excess capital to shareholders in the form of repurchases and/or higher dividends.
These justify much of the higher bank stock prices. However, just as the bank valuations implied an overly pessimistic future in January 2016, they now largely factor in the more optimistic future. Price/book ratios are now commonly in the 1.4x range, and price/earnings ratios are around 14x. Both of these metrics are on the high side of average. As valuations have moved up, risks have as well. Major disappointments in any of the drivers could push bank stock prices downward.
However, we continue to selectively like bank stocks, particularly our Recommended stocks. We think there is more upside potential, but we recognize that achieving the upside is largely dependent on continued increases in bank earnings and a steady macro environment. With their strong gains over the past year, bank stocks have proven the merits of focusing on buying low.
Disclosure Note: Accounts managed by an affiliate of the Publisher own securities of some of the banks mentioned in this blog.