While the broader market has cobbled together a nice run since Sept. 1, major financial stocks have been largely sitting out the rally. Though the S&P 500 has tacked on 11% and the tech-heavy Nasdaq has enjoyed gains of more than 14%, the big banks haven’t kept pace. Laggard Bank of America (NYSE: BAC) shares have actually been in the red over the last 10 weeks despite Wall Street’s surge.
But while other sectors have been stealing the spotlight, financials could turn around in coming months. A convergence of seven major trends could create a favorable environment for banks that create short-term and long-term profit opportunities.
Here are seven big reasons to buy banks now, before they take off:
#1 – Fed to Allow Dividend Increases
Income investors haven’t had much to love about banks since the dividend carnage of 2008 and 2009. Take Citigroup (NYSE: C) — in the summer 2008 the bank had an annualized dividend yield north of 7% with a 32-cent dividend paid Aug. 22 and shares trading at about $18. In October 2008, that payout was slashed in half to 16 cents, and it disappeared altogether soon after. Even “healthy” banks like Wells Fargo (NYSE: WFC) scorched the earth. WFC slashed its payout 85% in spring 2009, from 34 cents to just 5 cents, and Wells Fargo’s yield is a disappointing 0.7% as of this writing.
But lean dividend days may be over for bank stocks. The Federal Reserve is ready to sign off on increased dividend payments (for the healthy banks, of course) for the first time since the financial crisis. Details have not emerged yet, and regulators are sure to take a slow and conservative approach. But getting into these stocks now before the dividend boosts — and subsequent buying pressure from yield-hungry investors — could be an excellent move that pays off twice in the form of some nice share appreciation coupled with a quarterly payday.
#2 – Sector Rotation Favors Financials in 2011
Financials have essentially been dead money for the last year. The “best performing” major banks including Citi and PNC Financial Services (NYSE: PNC) slogged out 10% gains in the last 12 months compared with about 15% gains for the S&P 500 index. Not surprisingly, many investors and money managers have been avoiding banks like the plague.
A Nov. 5 report from Credit Suisse titled “Small & Mid Cap US Equity Strategy” indicates portfolio managers are severely underweight the entire financial sector — and as we move further away from the financial crisis and rays of hope peek through the clouds, institutional money is bound to return. The ride in tech and materials has been nice but likely won’t be duplicated in 2011. Tech-sector holdings are at four-year highs in small-cap funds, while the Credit Suisse report said financial stocks allocations are near mid-2008 lows seen when Lehman Bros. and Bear Stearns were about to evaporate. That bias against financials has to break, and it could break very soon.
So don’t wait until the institutional buyers bid up prices before you dip into bank stocks. You want to be ahead of the quantitative surge that lifts the entire sector by buying in now.
#3 – Foreclosure Filings Back on Schedule
“Foreclosuregate” and the robo-signing headlines seemed to weigh on the financial sector in early October. But bank stocks have bounced back in the last week or so, with a number of blue-chip financials outperforming the major indexes twice over. That’s because the foreclosure moratorium issue also appears to be fading and banks will begin shedding their inventories of empty homes again very soon. In fact, JPMorgan (NYSE: JPM) said late last week that it expects to start re-filing foreclosure documents by the end of the month.
Banks need to digest their inventory of foreclosed loans and subsequent vacant properties. The fact that the gears will start turning again is an encouraging sign. At worst, a regulatory or Congressional body may give banks a tongue-lashing and call for banks to better fund loan workout programs. Nobody in Washington is going to push for fines to punish the banks — especially those where the U.S. taxpayer is a major investor.
#4 – Earnings, Earnings, Earnings
The third-quarter earnings lineup from major financials speaks for itself. Here are the highlights:
JPMorgan Chase (NYSE: JPM) saw third-quarter profit rise 23%, and its $1.01 EPS topped expectations of 90 cents by about 12%. JPMorgan enjoyed $300 billion credit and capital raises in the quarter, and the amount of money set aside for bad loans dropped yet again.
Wells Fargo (NYSE: WFC) posted a record $3.15 billion in third-quarter earnings — a 19% percent improvement over the same period last year — and its earnings per share of 60 cents topped estimates of 55 cents by about 9%. The bank also cited improvement in credit quality as it charged off fewer loans, and even saw an uptick in checking accounts.
Bank of America (NYSE: BAC) earned $3.1 billion in Q3, blowing away earnings estimates with profits of 27 cents a share on forecasts of 16 cents — an earnings “surprise” of almost 70%. Of course, it must be said that those numbers came out alongside headlines that BAC is facing fraud charges and fines over $375 billion in mortgage-backed securities, and could be forced to buy some or all of them back.
Citigroup (NYSE: C) posted third-quarter earnings of $2.15 billion, and its EPS of 7 cents a share topped estimates by a penny. The gains were due thanks to a sharp reduction in bad debts, with provisions dropping to their lowest level since the second quarter of 2007.
U.S. Bancorp (NYSE: USB) profits leaped nearly 50% in the third quarter from a year earlier, and revenue grew 8% thanks to $54.8 billion in new lending activity. The earnings of $894 million equated to 45 cents a share and easily topped estimates.
#5 – Improving Credit Markets
Improvement in the credit markets – both on the consumer level and as it pertains to large business loans – is a great sign for banks since it means better earnings and fees from lending. And as the most recent round of earnings reports show, it also means fewer bad loans to write down and the need for smaller loss reserves.
On a consumer level, the improvement in credit metrics over the last two years has a lot of contributing factors. One is financial Darwinism, with many bad borrowers exposed over the last two years and subsequently cut off from loans, credit cards and even checking accounts. Another would be higher standard by banks, with a focus on asset-backed loans that naturally have lower defaults and fewer delinquencies than the easy money of the past. This has all added up to a much more stable — and profitable — consumer banking business.
On the corporate spending scene, though credit markets are still fairly quiet, it’s possible we could start to see leveraged buyout activity pick up in the next few months. As private-equity firms tap major financials for LBO loans, financial institutions will see profits from fees and related business.
#6 – Better Environment in Washington
Two years ago, there was a lot of harsh rhetoric coming out of Washington, D.C., about the irresponsibility and greed of major U.S. financial companies. By last July, the Dodd-Frank Act had been signed into law, with a range of provisions hitting banks, including limits on credit card and banking fees for consumers that could cost banks billions of dollars annually.
But this month’s power shift in the House of Representatives and reduction in the Democrats’ majority in the Senate also means a shift in how big banks will be treated on Capitol Hill. At the very least, investors will see a marked shift in rhetoric, and at best, some provisions of the new law could be rolled back or softened.
It’s clear that the economy is going to be the story again in 2012. Governance by revenge could have had an appeal while the financial crisis was fresh in voters’ minds, but the American people will want to see results in the economy in two years and not excuses. Being antibank just doesn’t pay politically right now.
#7 – Better Bank Balance Sheets Long Term
As Bernanke & Co. reverse course on the Fed funds rate and ratchet it up from its current rock-bottom levels, the move may actually benefit banks. That’s because with interest rates so low, even the most conservative investors have abandoned savings accounts. For instance, as Monday the “best” rate on a one-year jumbo CD according to Bankrate.com was 1.35% to 1.45% — with a minimum $100,000 buy-in! Why in the world would you give your money to a bank when returns are that anemic?
As the Fed ratchets up interest rates, banks will actually be able to increase their capital base and draw in conservative investors who are content earning 3% a year on a CD or high-yield savings account. This is a long-term trend that will take time to play out, but surely a good one for bank stability — and thus share prices.
The flip side is that higher interest rates could discourage lending and weigh on banks, but frankly with little lending at near-zero rates, that’s not a very convincing argument.
Jeff Reeves is editor of InvestorPlace.com. As of this writing, he did not own a position in any of the stocks named here. Follow him on Twitter at http://twitter.com/JeffReevesIP.