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 stocks.
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
1. Rising Interest Rates
"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 2015.
2. Reduced Refinancing Activity
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
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.
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
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 bank stocks.
5. Tighter Regulatory Pressures
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 ( MS ) and Bank of New York Mellon Corp ( BK ) ) could meet tightening capital requirements without the need to cut their dividends or alter their lending practices.
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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