Bank stocks have not been part of the recent market rally. That’s likely to change when the pandemic is finally behind us. And these two big banks should thrive.
The market is absolutely booming. All three major market indexes just made new all-time highs. That seems strange. Aren’t we in the grips of a global pandemic that’s getting worse by the day? What is it that the stock market seems to love about this Godforsaken year?
For one, the indexes are misleading. Take the S&P 500, for example. Five large technology stocks comprise what are collectively known as the FAANG stocks. Those are Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX) and Alphabet, formerly Google (GOOG). These five technology goliaths represent more than 20% of the index, and are up an average of 54% YTD.
Because the S&P 500 is cap weighted and these companies have grown so large, they represent a disproportionate share of the index. While these five stocks comprise well over 20% of an index of 500 stocks, the entire energy sector accounts for less than 3%.
And the technology industry is thriving during the pandemic as people rely on technology more than ever while locked down in their homes. The technology-laden Nasdaq index is up 38% YTD.
But the market indexes don’t tell the full story.
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Bank Stocks, Energy Sector Lagging
Many sectors are languishing. Stock performance in those sectors reflects the fact that the world is in the midst of a pandemic. For example, the energy sector is down over 34% for the year. Bank stocks are 5% lower for the year. These are cyclical sectors that are more affected by the real, Main Street economy, which has been severely disrupted by the lockdowns.
These sectors will require a more full recovery to rebound. While the economic recovery has outperformed expectations so far, it still has one arm tied behind its back with the restrictions that still remain.
But those downtrodden sectors got a huge shot of adrenaline this month as several promising vaccines appear on the verge of distribution. On the day of the first vaccine announcement by Pfizer (PFE), the KBW Nasdaq Bank Index soared more than 13%. The KBW Regional Bank Index jumped 16%. And those are indexes, in just one day.
Why the huge move? A vaccine could end the pandemic. The end of the pandemic means a more robust recovery that incorporates Main Street. A full recovery will lift the fortunes of bank stocks. And they’re still cheap ahead of what looks like much better times.
The primary way banks earn money is from net interest income (NII), the difference between the cost of capital and the rate charged to borrowers. As interest rates crashed during the pandemic, profits from NII have fallen with them.
The 10-year Treasury bond rate, a benchmark for longer-term interest rates, fell from 1.84% just before the pandemic to 0.53% by the summer. It is also down from a recent high of 3.23% in late 2018. In addition to lower spreads, banks also had to contend with falling loan demand during the shutdowns as well as a higher level of defaults, which accompany any recession.
But a full recovery will reverse those things. As loan demand increases, so will interest rates. As the recovery has gained traction, the 10-year bond yield has already increased from 0.53% to the current 0.93%. While the Fed may keep short-term rates low for a while, market activity will raise the longer rates and bank spreads.
There’s a lot of room to run. Interest rates are still priced for Armageddon. The 10-year yield (again, currently 0.93%) has averaged better than 2% for the last 10 years. As well, banks have been forbidden to buy back shares during the pandemic. The lifting of that restriction should also give several stocks a boost.
A full recovery next year would most certainly improve profitability at the banks, and consequently demand for bank stocks. And, with the banking sector recently selling at 20-year low valuations, the sector is a great opportunity in an otherwise expensive market.
There’s something else. The banking sector had a tough time in the last bull market. Banks were at the center of the financial crisis. Not only were many teetering near bankruptcy but even when they recovered they had to deal with a regulatory onslaught. Banks had to cut dividends and change their businesses. They never really came into favor in the last bull market. The next bull market is likely to be better for the sector.
Banks are also in far better shape coming out of this recession than the last one. They are far less leveraged and extended and much more financially secure. The common equity tier 1 ratio for the 100 largest U.S. banks (which measures core capital to risk-weighted assets and is used to gauge a bank’s financial strength) is currently at 11.3, versus 7.9 in 2007. And higher is better.
The recent upward move in bank stocks could be premature. The virus could hang around longer than expected. The vaccine may not end the restrictions. But the pandemic will end sooner or later. And the other side of the pandemic should be very good for most banks. It could still be a little early, but patient investors should be rewarded.
2 Big Bank Stocks to Buy Now
Of course, it matters which bank stocks you buy. My two favorites are large money center bank JPMorgan (JPM) and the nation’s largest regional bank, U.S. Bancorp (USB). These banks have remained profitable through the pandemic and have the efficiency to turn a much bigger profit when things improve far quicker than most competitors.
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*This post has been updated from an original version.
