Exactly three months ago on January 18, our Market Commentary discussed whether or not it might be time to increase exposure to bank stocks. We noted that following several years of dramatic underperformance, the sector had begun to outperform. We suggested that the recent strength in the sector had been due to 1) super-cheap valuations; 2) an improvement in fundamentals and earnings visibility; and 3) increased clarity with regard to a number of risk factors. We provided a list of positive developments that underpinned the strong relative performance for the sector. And we concluded by saying that the recent strong relative performance seemed likely to continue:
“As issues get cleared up, one by one, investor reticence with regard to bank stocks should continue to decline. We once again quote Joe Rosenberg, Chief Investment Strategist at Loew’s: “You can have cheap equity prices or good news, but you can’t have both at the same time.” In other words, it will be too late if we wait for all the risks and uncertainties to clear up. Bank stock valuations will have already risen to reflect the improved outlook.”
“As long as the visibility surrounding future bank earnings power continues to improve, we would expect valuations to improve and bank stocks to continue to perform well relative to the overall market. After the recent increase in prices, earnings disappointments or other bits of adverse news will likely cause setbacks. Those strike us as near term issues which may add to volatility but should not derail clear, albeit plodding, long-term progress.”
Since we wrote those comments early in the year, the Financials sector has been the best performing of the ten S&P 500 sectors (+13.4% versus +5.9% for the overall index). The Financials are now up 31.3% compared to just 19.3% for the overall market since the beginning of the current market rally on November 23, 2011. The dramatic rebound in bank stocks is a reflection of just how depressed the sector had become. So has the opportunity passed, or should we continue to expect outsized gains from the sector?
In our estimation, the strength in bank stocks to date has been almost entirely due to a correction from oversold valuation levels. As credit losses piled up following the financial crisis, many investors had simply deemed the sector too risky for consideration. Now that credit losses have improved, the housing market has stabilized, balance sheets have been made stronger, and regulatory issues are more clear, money has poured back into the stocks. This renewed investor interest was completely justified simply based on valuation. But this does not mean that fundamentals are back to normal for the sector. Recent increases in bank earnings have been highly dependent on lower credit losses. Banks continue to suffer from a large backlog of mortgage foreclosures, high loan servicing costs, margin contraction, weak loan demand, and outstanding regulatory issues such as the Volcker Rule. Until fundamentals improve, investors are unlikely to award the banks historical valuation multiples.
In other words, the low-hanging fruit has likely been harvested at this point. Further material gains in bank stocks will likely result from a return to industry health rather than the elimination of risk factors that had previously weighed down the sector. Banks cannot achieve earnings gains indefinitely from lower credit losses (or higher mortgage origination income, for that matter). These are lower-quality sources of income for banks, and the market does not assign as much credit as it would to spread income from loans, for instance.
Our base case scenario continues to call for a slow-growth environment as the consumer continues to delever, employment gains remain slow, and fiscal and monetary support is slowly removed. Under this scenario, loan growth, fee income growth and interest rate increases (which will help bank margins), are likely to be muted. If we are correct in our economic forecast, it might make sense to pull back a bit on the bank stock exuberance.