Big bank stocks have been on a tear in 2012. The Financial Select Sector SPDR ETF (NYSE:XLF) is up 20% and nearly lapping the broader market, led by Bank of America (NYSE:BAC), which has roughly doubled year-to-date.
So can bank stocks keep this up in 2013?
If there’s a secular recovery that results in increased lending, they very well could. We’ve seen what looks like the beginnings of a housing recovery, and that has resulted in an uptick in mortgage activity, boosting financials. Continued improvement in housing sales coupled with more business loans and (dare I say it) consumer credit expansion could result in a sustained rally.
But count me skeptical. Here’s why:
Not Cheap Anymore: Financial stocks are almost never growth investments — particularly mammoth plays like JPMorgan Chase (NYSE:JPM), the largest bank by assets, or Wells Fargo (NYSE:WFC), which commands a third of the entire U.S. mortgage market. So any investment — unless it’s a swing trade on sentiment — must be predicated on the idea that bank stocks are undervalued at this moment in time.
Current Mortgage Party May Not Last: An uptick in mortgage revenue has been beneficial to banks in 2012, pushing Q3 revenue growth to the best pace in almost three years. But record profits from offloading home loans to government wards Fannie Mae and Freddie Mac are unsustainable going forward. Consider that banks reportedly made $5.6 billion off of residential loan sales — more than triple the revenue from similar transactions in 2011! That surely is a good thing, but the favorable spreads on these loans and the rate of these transactions seem too good to be sustainable.
Cuts, Not Growth: Profitability has improved at many financial stocks. But don’t think it’s because of a wholesale recovery in lending, even if mortgage sales have been a boon. Consider that BofA cut loose 16,000 workers a few months ago. Just today, Citigroup (NYSE:C) made waves with the announcement of 11,000 layoffs. With these recent cuts, the financial sector has shed some half a million jobs in four years. This “addition by subtraction” is not a sustainable plan, even if it juices earnings in the short-term.
Merger Hurdles: Morgan Stanley (NYSE:MS) CEO James Gorman recently told an industry group that “the economies of regional banks don’t add up.” What he really should have said is the growth plans of many banks like Morgan “don’t add up” unless they can gain scale through acquisitions. After all, it’s the lack of growth and profitability that caused Moody’s (NYSE:MCO) to downgrade 15 major investment banks in June — including a two-notch cut to MS. However, it’s unclear whether a deal of scale would meet with approval from regulators in the wake off “too big to fail” bailouts. It’s clear the big banks need them … but do the smaller ones? If not, regulators may not play ball.
Consumers Have Options: In the case of retail banks like JPM or BofA, it’s important to remember that current and pending regulations including Basel III will require financial institutions to use less leverage and keep more capital on hand. So if customers continue to depart, that naturally limits the lending activity a bank can partake in. A survey earlier this year by Javelin Strategy & Research showed 11% of total bank depositors were “very likely or likely” to switch in the next year, with dissatisfaction remarkably high at the megabanks. About 25% Citibank customers and 21% percent of Bank of America customers told Javelin they are “very likely or likely” to switch primary financial institutions in the next year. Even if that number is inflated and some never switch, I think it speaks a wealth about consumer distrust in these institutions.
All this said, there are signs of life in financials:
- Bank revenue for Q3 did increase slightly year-over-year, even if the longer-term trend is clearly down. That signals that perhaps the worst is past and things have stabilized. And for the first time since 2009, the biggest contributor to the earnings was increased revenue rather than accounting tricks where banks tapped money set aside for loan losses rather than grew their business.
- “Problem banks” declined to under 700 for the first time in three years in the last quarter. And only 12 banks failed in Q4 — the smallest number since the end of 2008.
- Consumers seem optimistic, with consumer credit expanding almost continuously since mid-2010 despite macro fears and a number of recent encouraging spending data. That could bode well for overall lending activity and a broader economic recovery that would lift banks.
- Regionals remain very attractive, especially ones that weren’t gutted by the mortgage meltdown and have kept loyal customers and healthy loan portfolios. These smaller institutions lack the complexity and risk of big banks, often pay decent dividends and are often tied very clearly to local mortgage markets. Staking out a smaller bank in a healthy housing market would mean avoiding many of the risks listed above.
For the record, I would love to see banks soar in 2013. We should all be rooting for the financial sector — because it seems impossible that the American economy and the stock market will see a significant recovery without the full participation of financial institutions in that rally. So for the sake of my portfolio, our job market and the nation’s tax revenue, I truly hope 2013 is a good year for bank lending and economic growth.
Still, I remain skeptical that the roaring rally in major financial stocks can continue in 2013. A lot of the stability and optimism seems to be priced in, and the risks still are substantial.
Besides, if indeed there is a widespread recovery on the way, I have a lot of other stocks I’m interested in buying over a megabank like BofA with a 1-cent quarterly dividend and a troubled history.
Keep that in mind, too.
- Citi fires 11,000 just before Christmas … but sadly, that was the “right” thing to do. (The Slant)
- Chris Marasco ran down his reasons why bank stocks are risky a few weeks ago. (The Motley Fool)
- Tim Melvin says if you believe mergers will get approval, small banks might be a wise buy in anticipation of an M&A wave. (Money Morning)
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.