Beaten-up bank stocks could reflect too much gloom

Beaten-up bank stocks could reflect too much gloom

“People get smarter but they don’t get wiser. They don’t get more emotionally stable. All the conditions for extreme overvaluation or undervaluation absolutely exist.”So Warren Buffett told the Financial Times in an interview in April. And no sector of the US economy elicits more emotional tumult than banks — a sector that, as it happens, takes up a disproportionately large part of Mr Buffett’s portfolio. The strong feelings are understandable. The finance industry came close to crashing the world economy a decade ago. And two related factors are combining to increase the current levels of angst: worries that the long (if slow) economic expansion is coming to an end, and a topsy-turvy interest rate environment featuring long-term rates that have fallen below short-term ones.Both are bad for banks. Bank profits are very sensitive to economic growth, for obvious reasons. And an inverted yield curve tends to hit lending margins, especially when deposit rates, already near zero, cannot fall much more to absorb the impact of lower yields on assets.Cue ennui among bank investors. Over the past six months — roughly the period since one key measure of the yield curve first inverted — bank stocks have returned about 2 per cent, to the broader market’s 7 per cent. That includes a couple of percentage points most banks picked up on Wednesday, after the Federal Reserve cut rates with less oomph than the market had expected. That offered a glimmer of hope for banks’ bottom lines.The aggregate divergence may make sense. But it is in the performance of individual stocks where you see some big moves that may reflect over- or undervaluation.The most striking of all: JPMorgan Chase, which has returned more than 12 per cent since March — well ahead of not just almost every other bank but the market in general. Yes, the Park Avenue-based bank is believed by almost every Wall Street analyst to be well run. But this flight to safety trade is starting to look extreme. JPMorgan’s closest peer, in size and business mix, Bank of America, is flat over the same period.Yes, the composition of BofA’s asset portfolio makes it more sensitive to interest rates. But there is more to it than that, says Wolfe Research analyst Steven Chubak. He thinks people are recalling the events of 2008-09. “With late-cycle fears percolating, the firms that did [relatively] well during the financial crisis seem to be garnering the flight to quality benefit,” he writes.Mr Chubak thinks that investors are missing how much work BofA has done to improve the quality of its balance sheet since it melted down so spectacularly during the crisis. He cites the bank’s strong results on the Fed’s recent round of stress tests, where its projected losses over the imagined period of turmoil were among the lowest of all the big banks.A similar point might be made about Citigroup. Although the bank’s shares have put in a respectable performance over the past six months, its valuation remains depressed: it trades at around the tangible book value of its assets, suggesting minimal growth or significant losses ahead. JPMorgan trades at two times tangible book.Yes, JPMorgan is a better bank. But twice as good? Remember that Citi, of the big diversified US banks, is probably the least sensitive to interest rates, because so much of its business is corporate and fee-driven.Again, the valuation might make more sense in terms of Citi’s past than its present. It had the worst crisis of all, a fact that is burnt into the mind of every investor.There is a more general point to be made here, too. It is hard to remember it now, but until late last year, the market was convinced that we were finally entering a rising rate environment. That presumption evaporated overnight. While the central forecast now has to be for sustained low rates, the valuation of many bank stocks implies that a rising-rate scenario has been reduced to a probability of zero.There is a coterie of investors who think that the panic about growth and rates has created a buying opportunity. Among them is Chris Davis of Davis Funds, who argues that at the strongest of the big banks a combination of cost cuts, asset growth and share buybacks will be more than enough to offset the headwinds from low rates. “We feel good about being able to find good value in the sector without inordinate exposure to low rates,” he says.As most of the rest of the world focuses not on the banks’ businesses but the wider environment, Mr Davis’s bet looks deeply contrarian — but not irrational.robert.armstrong@ft.com


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