A few years ago, bankstocks were among the most
unlovedinvestments . Many of them traded well belowbook value and
also sported low price-to-earningsmultiples . Yet a pair
offactors has led investors to rapidly warm up to bank
First, the global economic crisis no longer seems to be a
mortal threat to bank's balance sheets. A long-anticipated crisis
simply never came to pass. Second, a sense that the U.S.
housingmarket -- a key source of bank profits -- was on the mend,
has led to expectations of a brighteningprofit forecast.
Indeed, second-quarter results are in from the major banks,
and they look quite solid.
A Solid Quarter For Leading Banks
As a result, after a 20% surge in the first half of thisyear
(compared with a 13%gain for the S&P 500), bank stocks have
rallied further in the early weeks of the third quarter. This
continues a trend that has been underway for nearly two
Yet behind the scenes, there are several moving parts that
might either derail the bankrally , or push these stocks even
higher. Here are five keyissues that may affect this group over
the next few years.
|1. Rising Interest Rates
Over the next few years, economists expect
interest rates to start moving higher. "Long rates," such
as the yield on the 10-year Treasury, are
dictated economic sentiment, and as the economy
strengthens, these yields are expected to rise from a
current 2.55% toward the 4% level.
"Short rates," which are pegged to the federal
funds rate (the Federal Reserve's benchmark
interbank lending rate), are not expected to start
rising for at least a few more years. (The Fed wants
to see unemployment at 6.5% before rates are
hiked, as I discussed in a previous column.)
For banks, such a scenario will be a headwind
before it becomes a tailwind. Over the next
few quarters , banks are expected to suffer from net
interest margin compression, which means their
profit spreads on loans will narrow as their own
short-term borrowing costs rise faster than the average
rate of loans they have issued to clients.
Over the longer term , banks start to make up for
lost time, as a firming economy means they can charge
higher interest rates (relative to their own borrowing
costs). Indeed, "net interest margin expansion" is a phrase
you may be hearing a lot more in 2014 and
|2. Reduced Refinancing Activity
Banks have benefited handsomely from the multi-year phase
of mortgage refinancings. As homeowners locked
in lower mortgage rates, they paid out lots of
fees to banks, most of which are pure profit. Yet the
recent increase in the 30-year mortgage rate to
4.35% (from 3.35% just a quarter ago) has already led to a
slowdown in refinancings.
If mortgage rates rise higher in coming quarters, then
this high-margin source of revenue will slow
even more. Many of the major banks noted this concern on
their recent quarterly conference calls, and the coming
months will give a clearer read on whether the era of
refinancing has officially come to an end.
|3. The Housing Rebound
A quick snapshot of housing stocks gives the impression
that sales of new and used homes are expected to
steadily rise over the next few years.
Indeed, a falling unemployment rate and a
wind down of the foreclosure crisis are key
factors behind a housing rally. And even if mortgage rates
rise higher, the housing affordability index
should remain above 140, which is typically a
positive level for home buying.
Wells Fargo (
Bank of America (
JPMorgan Chase (
are the nation's top three mortgage issuers, and they have
the most leverage to a housing recovery.
But will the housing market post a robust rebound, as
many anticipate? That question will be answered in the next
two quarters, when we find out whether the U.S. economy is
getting stronger, pushing up employment rates and consumer
confidence, or whether it will stall out in the face of a
slowing global economy.
|4. Global Exposure
The most remarkable aspect of the recently reportedearnings
reports is how events in Europe, China and elsewhere
appears to be having little negative impact on U.S. banks.
To be sure, these banks have not only reduced their foreign
exposure, especially in Europe, but have also deployed
betterhedging strategies to mitigatecurrency risk and other
Yet the operations of big banks are still closely
affiliated with trends underway atFortune 500 companies,
many of which have huge global footprints. More to the
point, if Europe hits another crisis point, there's no way
that bank stocks would remain unaffected. Banks have surely
benefited from a benign global backdrop in recent quarters,
but real risks remain and need to be monitored if you own
|5. Tighter Regulatory Pressures
The Federal Reserve intends to impose
tighter capital restrictions on banks, including
a requirement that these banks set aside more capital to
prevent another crisis like the one we saw in 2008 and
2009. The banking industry is none too pleased about the
Fed's proposals, and Congress, which counts on the banks as
their top source of campaign funds , my push back
against the Fed.
Yet investors shouldn't see such legislation as
a red flag. According to Merrill
Lynch analysts , "The adoption of the new leverage
standard would likely cause some banks to reduce
off-balance-sheet exposures." Although, they add that
almost all of the major banks (with the exception of
Morgan Stanley (
Bank of New York Mellon Corp (
) could meet tightening capital requirements without the
need to cut their dividends or alter their lending
Risks to Consider:
While a fresh European crisis has loomed in the past as the
greatest threat to these banks, the vigor of the U.S.economic
recovery stands as the greatest potential impediment.
Action to Take -->
Tally up the headwinds and tailwinds, and a case can be made for
a further rally in bank stocks -- assuming the U.S. employment
and housing market trends continue in a positive fashion. Yet
considering how far these stocks have already risen in the past
few years, it's unwise to expect robustgains in the quarters
ahead. Indeed, the recent rally appears to reflect the good times
still to come, and the wise course may be to lock in gains and
wade back in after the next solid pullback with this group.
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