The nation’s largest banks have been reporting earnings this week, and the results are mixed. Goldman Sachs, Morgan Stanley, PNC and JP Morgan all reported big top- and bottom-line beats relative to expectations, while Wells Fargo and Bank of America came in somewhat short of expectations. The market reaction to the Wells Fargo and BofA misses was predictable – both stocks suffered drops of 5-6% yesterday. But perhaps more surprisingly, the market reaction to the stronger earnings reports was muted, if not negative (PNC). So we thought we’d take a stab at explaining investors’ continued unwillingness to embrace this importance sector even after some blowout earnings reports.
In my opinion, there are at least five issues weighing on bank stocks and valuations:
- Third-quarter earnings were boosted by a big drop in loan-loss provisions. Generally speaking, bank management teams appear to be satisfied that the huge reserves added in the first and second quarters will be enough to cover the ultimate losses associated with COVID-19 and the recession. But even though credit-quality metrics (non-performing loans, delinquencies) remain encouraging, they are somewhat misleading given the reporting requirements of loans in forbearance or with other forms of payment relief. Consequently, there is an inordinate amount of uncertainty regarding the eventual losses that banks will sustain. The amount will be heavily dependent on the size and timing of the next round of fiscal stimulus, which does not appear to be imminent. Furthermore, the banks are telling us that even if a Congressional bill is passed, loss rates are not expected to peak until mid- to late 2021. Many investors are simply unwilling to invest over a time frame of that duration.
- The money center banks (JPM, GS, MS, BAC and C) had very strong quarters in investment banking and trading. Because these revenues are transactional and therefore non-recurring, banks never get full credit for revenues from these sources. Bank investors would rather see strength in the more recurring sources of revenue, like the net interest income they earn through taking deposits and making loans.
- The outlook for loan growth is very uncertain right now due to the economic uncertainty related to COVID. This issue is magnified as a result of the recent surge in new COVID cases and Congress’ inability to pass a fourth round of economic stimulus. Without loan growth, banks are forced to use customer deposits to buy low-yielding securities or park funds with the Fed (also at very low yields).
- Net interest margins have been decimated by the Fed’s interest-rate suppression, and there is no end in sight. The central banks have insinuated that short-term interest rates could remain at rock-bottom levels for several years into the future. Because many bank loans are tied to short-term interest rates, net interest margins will continue to weigh on bank profitability for an indeterminant period of time.
- We learned on September 30th that the Fed is extending its moratorium on stock buybacks for large banks. The Fed will also extend its limitation on dividends, which requires that large banks limit their dividends to no more than their average earnings over the previous four quarters. The dividend restriction is even more onerous than it appears because banks have been aggressively adding to loan-loss reserves in recent quarters, which has suppressed earnings. Wells Fargo and Capital One had to cut their dividends due to this restriction, and others may have to follow suit. At the very least, this restriction negatively affects one of the best investment cases for owning bank stocks prior to the pandemic: capital returns.
Ownership of bank stocks today requires that an investor make the assumption of another round of fiscal stimulus. If the economy does not get that help, there is likely to be a deep and painful recession as legions of small businesses fold and unemployment spikes. And while I’m in the camp that believes more aid will be forthcoming, that doesn’t mean that it’s safe to buy bank stocks indiscriminately. We believe this is a time to own the highest quality banks with the strongest capital ratios and the ability to be opportunistic amidst the carnage. Sticking with quality will still allow investors to benefit from the significant positive investment attributes for the sector: 1) current low valuations are already pricing in the very difficult operating environment; 2) capital ratios and reserve levels are very high right now, and this economic downturn was not triggered by the housing market or other financial system-related excesses; and 3) dividend yields for quality banks are very attractive, especially with the 10-year Treasury note yielding just 0.70%. In my view, investors with a longer-term investment horizon (3-5 years) may look back with regret if they don’t have some exposure at today’s bargain-basement levels.