Wall Street banks can’t stop telling investors to buy shares in Wall Street banks. It’s not been the best advice.
Financial shares have the third-worst performance among 11 S&P 500 Index groups in 2017, and are on track for the poorest year relative to the market since 2011. Yet of the 10 equity strategists surveyed by Bloomberg, nine give banks and insurers the highest recommendation and only one holds a neutral view.
That’s in stark contrast with their stance on the rest of the market, where market leaders from technology to health-care fetch no more than four buys. Every group other than banks garners at least one sell rating.
There has been no shortage of defensible reasons to be bullish on banks at various times this year. They’re viewed as the biggest beneficiaries of the Trump administration’s promise to loosen regulations and cut taxes, and lenders looked set to rally when the Treasury curve steepened amid tighter monetary policy. It’s just that, so far, none of that has happened.
Call it misplaced love, but prognosticators from Goldman Sachs Group Inc.’s David Kostin to Savita Subramanian of Bank of America Corp. haven’t given up just yet. The rally is coming, they say, and it’s not reliant on the Fed tightening. Donald Trump and Congress will eventually ease regulations and cut taxes. Banks also offer a valuation discount and plan to boost buybacks.
“What the market is getting really wrong right now is the fact that financials are trading in lockstep with the 10-year. It’s insane,” Subramanian said in an interview on Bloomberg Television earlier this week. “What’s not to love about a sector that’s cheap and is returning cash to shareholders?”
Strategists are not alone in sticking to their optimism. Investors in exchange-traded funds have added $4.3 billion this year to those focused on financial shares, the second-most among sectors tracked by Bloomberg.
Bulls have gotten some validation this week, with banks jumping 3 percent to the top performance in the S&P 500 Index as it barrels toward 2,500. The rally has been mostly driven by a rebound that lifted 10-year Treasury yields from their 2017 lows. Here is a sampling of other things that strategists say will push bank shares higher.
This year marks “an inflection point” in the amount of capital the Fed allows financial companies to return to shareholders, Kostin wrote in a note last month. According to estimates from the firm’s banking analyst, Richard Ramsden, total payouts in the form of dividends and buybacks could grow at an average annual pace of 19 percent through 2020.
Goldman equity-derivatives strategists including Katherine Fogertey and John Marshall said financial shares have given back their post-election outperformance and more, leading to opportunities for bulls.
Bank of America
Easier regulations will boost profits for lenders, whose regulatory and compliance costs have grown to almost one-fourth of operating expenses, up from 14 percent in 2007, according to estimates from the firm. Deregulation could boost return on equity for the banking industry by as much as 3.5 percentage points by 2020. The ratio of profitability stood at 11.3 percent in 2016.
Tobias Levkovich attributes financial shares’ underperformance to “a very disbelieving investment world,” where many investors view the industry’s existing business model under threat from tech innovations at a time when loan demand is weakening and yield curve is flattening.
But things are poised for a turnaround. Take 10-year Treasury yields, which Levkovich says have mirrored the firm’s economic surprise index closely since 2010. The fact that the measure showing the economy has started to perform better than economists’ forecasts bodes well for yields, and therefore banks.
At the same time, loan growth may give another boost to the banking industry. Commercial and industrial lending took a hit in 2015 and early 2016 as a collapse in oil prompted banks to curb funding commitments. With credit conditions easing since the second quarter of 2016 and loan patterns usually lagging lending standards by six quarters, Levkovich expects lending to pick up starting later this year.
“Loan growth could be a major upside surprise for wary investors,” he wrote in a note earlier this month.
Strong profit growth and low valuations underscore Bankim Chadha’s bullish call. Except for energy, banks are the only industry where earnings are expected to grow at least 10 percent each year through 2019, analyst estimates compiled by Bloomberg show.
Yet their stocks are trading at a discount to fair value. According to the firm’s model that incorporates growth, payouts and leverage, financial shares are trading 19 percent below their fair value. That’s more than any other industry.