U.S. bank stocks provided investors with a tremendous 38 per cent return in 2013 and to date, fourth quarter earnings reports suggest more room to run in 2014. Interested investors, however, will have to keep a close eye on the U.S. yield curve.
Investors jettisoned U.S. bank stocks during the financial crisis on justifiable fears that clever accounting was hiding substantial balance-sheet risk. As a result, average valuation levels plunged.
The average price to book ratio for the KBW Bank Index (used because it includes more prominent banks than the S&P 500 benchmark) fell from over two times at the end of 2006 to less than one half times book value by mid 2009.
Trailing price to earnings started 2007 at 14-times earnings, ballooned to over 1,100 times in 2009 as profits (the denominator in the P/E equation) evaporated, before bottoming in 2011 at 8.5 times earnings.
KBW U.S. Bank Index vs KBW U.S. Bank Index Price-to-Book Ratio
SOURCE: Scott Barlow/Bloomberg
Bank valuation levels in 2013 imply a steady return of investor confidence in the sector. It was the first year that average price to book ratios remained above 1.0 since the crisis. Similarly, the index price earnings ratio climbed above 12 for the first time in years as a clear sign that the market was left sceptical about the banks' financial future.
The current price to book ratio of 1.2 times remains well below pre-crisis levels and the same is true of the current trailing P/E ratio of 12.6. Bank stocks may not trade at 2006 levels for some time, but it does appear there's room for appreciation before they become prohibitively expensive.
Bank of America Corp., Wells Fargo & Co. and JPMorgan Chase & Co. have already posted fourth quarter earnings and in each case, profits met or exceeded consensus estimates.
The outlook remains positive, but there are two important caveats. In the first case, investors need to watch for profits boosted by one-time accounting adjustments. JPMorgan's results featured a $500-million (U.S.) decline in funds held in case of client loan defaults. This sum was added to profits for the quarter but, with only $100-million left as provision, the same method can't be used to supplement earnings results next quarter.
Investors looking to add bank stock to their portfolios also need to pay close attention to the U.S. yield curve. In an earlier post, I explained the sensitivity of bank stocks to changes in the shape of the Treasury curve. An increase in two year U.S. yields could cause the curve to flatten and this would be a significant hurdle for bank stocks.
Overall, the outlook for U.S. banks is bright and valuations remain attractive relative to history. Stocks in the sector are expected to benefit both from the slow return of investor trust and a recovery U.S. economy.