Rising Bond Yields Make Banks Attractive

|
Includes: BAC, USB, WFC
by: Insider Monkey

Summary

The yield curve is steeper than before, making banks more profitable.

Because they are more profitable, banks will pay higher dividends.

With many banks trading at forward PE’s of 10-12, the banking sector is cheap.

By Jay Smith

The yield rally in the ten year is good for banks, who borrow at short term rates and loan out money at long term rates. Since the Federal Reserve has yet to raise the Federal Funds rate, short term rates are very low and haven't increased as much as long term rates. Short term rates will not rise as quickly as the long term rates for a while, as Janet Yellen said that the rate increases will be gradual and only if the economy is prepared for it. The steepening of the yield curve will increase bank earnings, making banks more attractive and allowing them to beat expectations.

Today's banks are no longer the zombie banks of the past. After spending five years increasing their liquidity reserves to meet regulators' demands, the major banks have enough liquidity to survive almost any worse case scenario. According to the Federal Reserve, even Bank of America (NYSE:BAC), the bank that many thought needed to be recapitalized in 2011, has enough liquidity to survive a 50 percent drop in stock prices, a 20 percent decline in housing prices, and an U.S. unemployment rate of over 10%.

The scenario of unemployment rising above 10% is unlikely now. The U.S. economy is doing well. Home prices are rebounding, with the Case-Shiller U.S. National Home Price Index at 168.03, the highest since 2008. Unemployment is 5.5%, near a multi-year low. Even wages are increasing, with average hourly earnings increasing 2.2% year over year.

Strong economic activity makes making loans easier, as there are more credit worthy customers for banks to loan to. Strong economic activity also reduces the number of non-performing loans, which increases bank margins. Because of these factors, bank profits will accelerate and returns on equity will increase, allowing banks to spend more money on buybacks and dividends. Given that large banks trade at cheap forward earnings ratios of 10 to 12, the prospect of higher earnings, more buybacks and dividends, could be the catalyst needed to send financial stocks higher.

Many hedge funds and famous investors own the big banks. Warren Buffett's Berkshire Hathaway owns 470 million shares of Wells Fargo (NYSE:WFC), making Wells Fargo Buffett's largest position in his portfolio. Buffett's position in Wells Fargo is so big that it makes up 23.88% of his total stock holdings. Buffett also owns 83 million shares of U.S. Bancorp (NYSE:USB), making U.S. Bancorp Buffett's 7th largest position. Although Wells Fargo and U.S. Bancorp trade at higher price to book ratios than J.P. Morgan or Bank of America, Wells and U.S. Bancorp are less risky. They have less exposure to Europe if the Greece situation gets out of control. They will outperform the larger money center banks in bad times.

Following the picks of hedge funds and famous investors is a winning strategy. Our research shows that the 15 most popular small-cap stocks among hedge funds and famous investors have outperformed the market by nearly a percentage point per month between 1999 and 2012. We have been forward-testing the performance of these stock picks since the end of August 2012. These stocks managed to return more than 132% over the ensuing 2.5 years, and outperformed the S&P 500 index by nearly 80 percentage points (read the details here).

With the U.S. economy recovering nicely and the yield curve steepening, banks earnings will beat expectations. Because the major too big to fail banks are adequately capitalized, the Fed will allow banks to pay more in dividends and do more share repurchases, increasing the share price of banks.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.