Why Banks Are At The Top Of My Shopping List

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About: Financial Select Sector SPDR ETF (XLF), BKX, Includes: C, KRE, WFC
by: Ian Bezek
Summary

A recent article made the case for avoiding the banking sector.

That's been a great call over the past year.

However, I think we could be closer to the turning point than most people expect.

Thanks to industry changes, bank stocks have much less downside than they used to even if my timing is off.

A recent article suggested that investors should keep avoiding banks and gave reasons why. As the article topped Seeking Alpha's trending list for quite awhile, it clearly resonated with readers. I'd like to offer a counterpoint to author Eric Basmajian's view. I agree with him on many of the reasons why banks (XLF) have underperformed over the past 18 months; he's summarized the problems facing banking stocks recently well.

But as investors with a decent time horizon, it's worth asking where we'll be over the next 18 months or five years. If you're coming at things from a trading perspective, that may not be the best approach - in the short-term, many of the factors Basmajian points out could keep weighing on bank stocks even more. However, I think investors that acquire banking shares at current prices and then hold them for the next several years will significantly outperform the S&P 500.

The Banking Sector Is In A Bear Market. But Why?

There are various reasons you can point to for why banking stocks have struggled. Economic indicators have shown some retreat in the U.S., with things such as manufacturing activity and new job creation dipping from last year's elevated levels. Globally, the economic picture has weakened a great deal over the past year. The trade war has intensified strain on the Asian exporting economies in particular.

There's also the matter of slumping interest rates, and thus, for domestic banks, falling Net Interest Margins. The 10-year treasury yield, for example, has slid from nearly 3.25% at its peak to under 1.7% recently. That's, in effect, six 25 basis point rate cuts worth of movement in the longer end of the curve where banks make many of their loan products such as mortgages.

The short-end of the curve, however, has barely come down. The Fed was hiking rates as recently as last December and just made its first cut recently. This is bad news for banks, as the rates they can get on loans such as mortgages has plummeted over the past year. This compresses margins badly. But they haven't been able to lower the rates they pay on deposits such as savings accounts and short-term CDs (yet). We'll come back to this. In any case, bank earnings have been far less impressive in 2019 than they were last year, when NIMs were rising and the corporate tax cut was giving the sector a big boost.

Basmajian also points out how share buybacks have failed to juice banking stocks. It's true that over the past year, we've seen a great deal of share repurchases in the industry - particularly with the large national banks - and yet share prices have been flat to down even among heavy share repurchasers.

Wells Fargo (WFC), for example, reduced its outstanding share count by 9% over the past year. Its stock price, however, is down roughly 15% since last summer. Citibank (C) bought back 10% of its stock last year, and its share price is lower as well. Clearly, at least in the short-run, share buybacks aren't enough of a positive catalyst to offset deteriorating industry conditions - such as falling Net Interest Margins.

I give Basmajian credit for making a great call on banks last year at the top of cycle. I personally bought banks heavily in 2016 and slowed down on purchases in the sector after the big Trump rally. But I never turned bearish on the sector, and, with hindsight, that would have been a good move last year. I'm not convinced that this is the time to keep pressing the trade, however. Take the spread between utilities and banks, for example.

Since the start of this bull market, regional banks (KRE) are up 250%, compared to utilities which have gained 170%. Not surprisingly, banks were absolutely crushing the utilities until last year, and still have a sizable performance advantage even after the recent troubles.

That's to be expected. In both the U.S. and overseas, financials have outperformed utilities over the long haul. Banks are an inherently higher-return business than utilities since they don't have huge CAPEX needs nor do they face so strict regulations on pricing and profit margins. For a long-term investor, you want to own more financial stocks than utilities unless you're extremely risk averse. Also, financials make up far more of the economy and market cap of the S&P 500 than utilities, so if you're trying to stay reasonably correlated to the economy and market, you should think about buying financials when they are on sale. And compared to utilities they certainly are now:

Chart
Data by YCharts

Depending on when this bond rally runs out of juice, I could see utilities outperforming banks for another few months or quarters. Or perhaps this trade will reverse tomorrow; it certainly looks like we may have gotten capitulation in bond yields last week. In any case, fast forward three or five years from now, and banks have a great chance of outperforming utilities from here.

Keep in mind, also, that the share buybacks aren't letting up. For many large firms, they are actually accelerating this year. The longer buybacks keep up at depressed prices, the more upside the financials will see when the cycle turns in their favor again. With the Fed joining the world's great monetary easing party, people might be surprised at how strongly economic numbers come in next year. If so, banks, with their newly trimmed-down share counts, will be set to launch.

Why Banks Will Turn Around Soon

The first thing that excites me about banking stocks here is sentiment. When positioning in a sector hits an extreme, you often have a good buying opportunity, particularly if you are willing to hold for a little while. It's dangerous buying falling knives, after all as extreme moves can keep going past where anyone would expect. But when people capitulate, there's generally value to be had. So where are we on banks? From this past Friday, we have this:

Source

I'd also note that some people have a simplistic view of how the Fed impacts banks that goes "rate hikes are good, rate cuts are bad". There's more nuance though. In actuality, it's the shape of the rate curve that matters much more. The market is saying, rightly or wrongly, that the Fed hiked rates too far and now needs to cut them.

Suppose the market is right and the Fed ends up cutting another three or four times over the next year. What happens? It's actually good news for banks. With each short-term rate cut, banks can lower the rate they pay to depositors by roughly 25 basis points. Meanwhile, the yield on their new mortgages and other loan products only drops if the 10-year and 30-year yields fall even farther. However, as I mentioned above, the market has already priced in roughly six cuts to this end of the curve:

10-year U.S. Treasury Yields - Source: Trading Economics

Any bounce upward in the chart improves banks NIMs and profits going forward. And even many bond bulls would admit this move is overdone at least in the short-run. On the short-end of the curve, where banks pay for their funding, the move has been far less dramatic. Thus, we're likely near the bottom of interest margins and banking profits for the time being.

Bullish Macro Factors For Banks

Basmajian concludes his article with the following takeaway:

Until we have a sufficient turn in the economic cycle, bank stocks will have an uphill battle and should likely remain on your avoid list for the time being. When the cycle turns and growth inflects higher, bank stocks will be a great investment, likely outperforming the S&P 500.

I agree with that sentiment. However, I'd suggest we may be at the turning point in the economic cycle right now. We've just seen a breathtaking capitulation in inflation expectations, as measured by the massive decline in bond yields. Yet economic numbers in the U.S. are still reasonably strong, and now the Fed has swapped from a hawkish stance to an aggressively dovish one. All else equal, the Fed's directional changes tend to have an outsized impact on where the market goes, but it takes a few quarters for monetary changes to hit Main Street. We're still seeing the tail end of the squeeze the Fed put on growth with its last rate hike in December.

Three or six months from now, as the easing policy starts to affect the economy, we'll see cyclical trend markers turn upward. As it is, job growth, consumer confidence, and so on are still reasonably strong, if not where they were in 2018.

I'd also note, from a longer-term perspective, the banks are in far better shape than they were in past years and decades. The capital ratios are near multi-decade highs for the industry. As it was, capital ratios were already rather high going into 2008, which is why far fewer banks failed then - contrary to popular understanding - as opposed to the thousands we lost in the 1980s and early 1990s (Data from SA author Richard Parsons and his book Broke.)

I'd also note that new bank formation, while it has ticked up slightly in the past year, is still running at less than 20% of the levels we saw leading up to the 2008 crisis. Historically, new bank formation is strongly tied to banking crises, as hot money and inexperienced directors flood into the industry. The absence of new bank creation is thus quite bullish for the industry. The combination of nearly no new banks being formed now, historically elevated capital levels, and slow loan growth speak to an industry that is hunkered down and prepared for the worst.

Even if I'm wrong and the banking cycle doesn't turn up over the next few quarters, downside here is limited because the industry is already playing defense.

You can buy great franchises like Wells Fargo at less than 10x forward earnings with a greater than 4% dividend yield and them buying back 10% of the float annually. Even in a steady-state net income situation with no growth, you're getting close to 15% annual total returns off that starting basis. That's likely to crush the S&P 500 in general and defensive stocks like utilities in particular in coming years.

Banks could keep underperforming the market for a time - it's hard to catch the exact end of the pendulum's swing - but the trade is long in the tooth. When banks turn up, the gains will be rapid.

Disclosure: I am/we are long WFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.