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Wall St Week Ahead: Bargain or trap? US bank stock outlook hinges on Fed's path

The S&P 500 bank index is down around 11% in 2023

Bargain hunters are swirling around beaten-down shares of US banks, even as skeptical investors say the sector’s problems are likely to persist for some time.

The S&P 500 bank index is down around 11 per cent in 2023, a year that began with the failure of Silicon Valley Bank and several other lenders in the worst banking crisis since 2008. The broader S&P 500, by contrast, is up around 15 per cent.

Bank stocks are at an all-time low compared with the S&P 500 based on relative prices, according to data from BofA Global Research. That tumble has made their valuations attractive to some investors: the sector trades at eight times forward earnings, less than half of the 19.7 valuation of the S&P 500.

“Right now, you can’t say for sure whether the attractive valuations are merely a value trap,” said Quincy Krosby, chief global strategist at LPL Financial, referring to a term describing stocks that are cheap for good reason.

One key factor for bank stocks is whether the Federal Reserve is close to wrapping up a monetary tightening cycle that has brought the highest US interest rates in decades.

Elevated rates allow lenders to charge customers higher interest. But they also increase the allure of short-term bonds and other yield-generating investments over savings accounts, while hurting demand for mortgages and consumer lending.

Few investors believe more rate increases are in store. Yet signs the Fed may keep rates around current levels through most of next year have weighed on bank stocks. Nevertheless, some contrarian investors appear to be moving into the sector: the Financial Select Sector SPDR Fund received net inflows of $694.59 million in the week ending on Wednesday, its best weekly showing in more than three months.

This month, analysts at BofA Global Research said investors should “selectively” add exposure to bank stocks in anticipation of an interest rate peak. Most risks to the sector stem from higher rates, they said, including margin pressure due to rising deposit costs and problems with commercial real estate.

Famed investor Bill Gross said last week he believed the sector had hit bottom and added he was holding a number of regional bank stocks, fueling sharp rallies in their shares.

“We think there is a lot of hidden value in banks if you are selective,” said Neville Javeri, a portfolio manager at Allspring Global Investments who is overweight banks relative to the S&P 500 in the portfolios he manages.

Javeri believes larger banks have significantly cut costs and are poised to raise dividends and increase buybacks, helping them weather a period of slower loan growth.

Among stocks recommended by BofA’s analysts are shares of Goldman Sachs and Fifth Third Bancorp.

Investors are awaiting US consumer price data next week, for a glimpse of how the Fed is faring in its fight to keep lowering inflation from last year’s multi-decade highs. A sharper than expected fall could bolster the case for the central bank to cut rates sooner.

Many investors and analysts remain pessimistic on bank stocks.

Historically high mortgage rates have weighed on lending. Overall, about 61 per cent of all outstanding mortgages have an interest rate below 4 per cent, according to the Apollo Group, leaving consumers little incentive to refinance or move. The average contract rate on a 30-year fixed-rate mortgage dropped in the week ended Nov. 3 by a quarter percentage point to 7.61 per cent, the lowest in about a month.

Meanwhile, analysts have been cutting growth estimates for financials, which includes not only banks but insurance companies, as the Fed maintains it will keep rates higher for longer. This could hurt mortgage loan growth.

The financial sector is expected to post earnings growth of 6.2 per cent in 2024, nearly half of prior estimates from April that showed 11.4 per cent earnings growth, according to LSEG data.

“You don’t have any certainty that you’ve seen the worst of it and things are getting better,” said Jeff Muhlenkamp, lead portfolio manager at Muhlenkamp & Company.