The general consensus has been that banks and other financial services companies will begin seeing their earnings rise once the Fed starts to move interest rates higher. The million dollar question has been when exactly will that happen. Following the December 2015 rate hike, the Fed Dot Plot report indicated that members were preparing to move the Fed Funds rate higher perhaps as many as four times in 2016. So far, the can has continued to get kicked down the road as a combination of Brexit, slower than expected growth and low inflation have put the Fed on pause.
The Fed, however, is looking like it's finally getting ready to move and that's been a good thing for bank stocks. Since the Brexit vote low on June 27, the SPDR S&P Bank ETF (NYSEARCA:KBE) has returned nearly 22%, largely on the prospect of higher rates on the way. During the same time, the S&P 500 has returned 7%.
Despite the recent run up, bank stocks look significantly undervalued compared to both the broader market and the industry's historical norms. According to a recent Goldman Sachs (NYSE:GS) research note, banks represent the second cheapest segment of the market right now behind only automobiles. The forward P/E ratio of banks is at around 11 compared to the 17 multiple of the S&P 500. The price-to-book value ratio tells a similar story where banks are the only market segment trading below book value as a whole.
Part of the reason banks are so cheap right now is that nobody expects much of them. Even if the Fed starts raising rates again, it has a long way to go before the yield curve could be considered "normal" again. While many of the banks have gone to great lengths to beef up their capital positions and make their balance sheets both leaner and cleaner, there's still a great lack of trust for Wall Street executives and a significant concern that any positive financial results are, in fact, real. The specter of the Wells Fargo deposit account scandal has once again renewed fears of fraud taking place within the financial services industry.
Despite this, investors should also give weight to some of the positive catalysts that could give the banks a good tailwind. Outside of valuation, many banks are clearing the CCAR stress testing hurdles put in place by the Federal Reserve Board and are preparing to return a greater percentage of excess capital back to shareholders in the form of dividends and stock buybacks. Citigroup (NYSE:C), for example, is targeting a return of roughly $16 billion back to shareholders in the next year or two. Compare that number to the $10 billion it returned in 2016 and $7 billion in 2015. Returning that degree of capital back to shareholders should significantly boost both the dividend yield and the share price, through a reduction in the number of shares outstanding. Citigroup is just one example but many of the big banks are in similar situations. Banks are also cleaning up their balance sheets by reducing expenses, scrubbing bad loans off the books, eliminating debt and dumping non-core assets.
To be fair, bank stocks are not without risk even at already depressed levels. Brexit remains a concern of which we still don't understand the potential impact. The earnings recession we've seen over the past several quarters could end up turning into a real recession in 2017 which would likely put a hold on any further rate hikes.
Right now, however, the overall risk/return tradeoff of the banks looks fairly compelling. Even after their recent run-up, banks look like they're still at an attractive entry point for long-term investors.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.