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Big Banks on the Mend – Part 2

In part 1 of this series, I discussed the Federal Reserve’s “stress tests” for big banks, known as the Comprehensive Capital Analysis and Review (CCAR). I highlighted how investor fear about the financial services sector has created attractive investing opportunities. Today, I will analyze the fundamentals of several big banks to pinpoint the most attractive stocks to buy.

The Federal Reserve Board conducts stress tests on financial institutions with $50 billion or greater in total consolidated assets. Instead of looking at all 35 of the companies that the Fed tests, I’ll focus on six of the well known big banks: Bank of America (NYSE: BAC), Citigroup (NYSE: C), Goldman Sachs (NYSE: GS), JPMorgan Chase (NYSE: JPM), Morgan Stanley (NYSE: MS), and Wells Fargo (NYSE: WFC). 

Four of these six companies passed the CCAR stress tests completely, receiving “non-objection to capital plan” grades from the regulators. Two of them, Goldman Sachs and Morgan Stanley, also passed but weren’t allowed to increase their capital returns above 2017 levels because of “conditional non-objection to capital plan” grades.

As you can see in the graphic below, both Goldman Sachs and Morgan Stanley increased their dividends and announced stock buybacks for 2018, but their capital return levels (share buybacks) are well below their peers.

Simply put, outside of Goldman Sachs, these capital return figures (dividends paid plus share buybacks) to shareholders are fantastic. 

The S&P 500’s dividend growth rate (DGR) last year was 8%. The DGR of the SPDR S&P 500 ETF (SPY) over the last 5 years was 11%, compared to 6% over the last 20 years.  No matter how you slice it, the strong, double-digit dividend increases offered by the big banks last week are well above the broader market’s averages. 

The banks have struggled throughout much of 2018. Because of the reflation trends of the “Trump rally,” they were a popular analyst pick coming into the year. But since January, bets in this sector haven’t paid off.

One would think that in a rising rate environment the well-capitalized banks would be gaining ground, but fear of an inverted yield curve has held them down.

The difference between the U.S. 2-year Treasury bond and the 10-year Treasury bond has narrowed throughout 2018 and currently sits at its lowest level since 2007. An inverted yield curve has served as an indication of oncoming recession for decades.

The chart below, compiled with data from the San Francisco Fed, shows that an inverted yield curve has predicted every U.S. recession since 1995 (source: Business Insider). 

Banks don’t typically perform well during tough economic times, so I can’t blame the market for caution with regard to this sector.

With that said, since the late 1970’s, the average time between an inversion and the actual onset of recession is 16.6 months. Historically, during those 16.6 months, the market has done quite well. 

Consequently, while the narrowing yield curve is certainly worth monitoring, it appears that the threats it indicates are well off into the future.

What is on the horizon for big banks is the seasonality that they typically experience during the second half of the year. This seasonality has helped the banks perform well in the second half of the past two years.    

What’s more, as shown in the first graphic above, the banks all have massive buyback authorizations that will go into effect once we exit the second quarter earnings period. The billions that the banks spend on buybacks should put a floor under their stocks and could drive share prices higher. 

Lastly, it’s expected that we’ll see a solid gross domestic product number for the second quarter. A strong economy implies business growth that in turn implies loan growth, which is great for the big banks. 

The upshot: maybe all of those people who were bullish on the banks heading into 2018 weren’t wrong. Perhaps they were just early. 

That’s a bet I’ve been willing to make personally. I’m long shares of Bank of America, Citigroup, and JPMorgan. All of these names are trading with near single-digit forward price-to-earnings (P/E) multiples and I’m looking forward to collecting their recently increased dividends while I wait for market sentiment to change.

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