Bank of America Corp (NYSE:BAC) reported pretty strong quarterly results in October. Despite a slowdown in investment banking, BofA still beat earnings expectations. It didn’t do much for BAC stock though.
The company missed on revenues, and when you look further at the situation, you see more and more weaknesses in BAC’s story. Management has done a great job reviving the company. But when BAC stock is up 60% over the past year, you need more than that. I fear this is as good as it gets, and BAC stock will sell off soon.
Bank of America Is No Longer Undervalued Versus Peers
BAC stock has come a long way since early 2016. In less than two years, BAC stock has rallied from a low of $12 to $27. That’s a 125% gain. Over the same stretch, its major rivals all rallied, but to a significantly lesser degree. Goldman Sachs Group Inc (NYSE:GS) is up 54%, JPMorgan Chase & Co. (NYSE:JPM) rose 70%, Citigroup Inc (NYSE:C) rallied 81%, Wells Fargo & Co (NYSE:WFC) is up just 14%. The sector ETF, Financial Select Sector SPDR Fund (NYSEARCA:XLF) gained 26%.
This reflects investor sentiment more than anything. If you look at the gains, the banks previously viewed as safest, such as Wells Fargo, massively underperformed. Meanwhile, the banks that fared the worst during the financial crisis, such as Citigroup and Bank of America flew up the fastest. This came not from superior operating performance, but instead from investors finally abandoning the financial crisis mentality and looking at former dogs like BAC and Citigroup with a fresh set of eyes.
In November 2017, however, there is no stigma left on former worst of breed banks like BofA. Of its immediate peer group, BofA (15.8x) actually has the highest PE ratio at the moment. Goldman Sachs, a clearly superior bank, is at just 12x earnings, and well-managed JP Morgan is at 14x.
It’s hard to justify this on operating performance either. On key metrics such as Return on Equity “ROE” and profit margin, BAC tends to rank in the middle of the pack or lower. One point in Bank of America’s favor, their price/book ratio is still lower than their peers. But bears would argue that is justified given that there is little evidence that BofA has better assets than its peers.
Bank of America Has No Meaningful Advantage
To justify a higher PE ratio than its peers, Bank of America would need something that makes it stand out. However, it’s unclear what BofA’s distinctive edge is.
Are they the country’s leading investment bank? No, that’s Goldman Sachs or JP Morgan. BofA is a strong third, but third doesn’t merit first-place valuation. Are they the largest bank overall in the U.S. by total assets? No, Bank of America is number two there, again trailing JP Morgan. Wells Fargo still dominates U.S. mortgages. Again, Bank of America has a strong position, but not the leading one.
Bank of America’s post-financial crisis strategy has been to focus on higher-quality customers. Their average FICO scores on new loans are substantially above the median. Unfortunately, that appears to be the new norm for most of the large U.S. banks. Non-traditional lenders are picking up more of the slack with lower credit score borrowers as the huge national banks all try to avoid repeating the errors of 2008. Other BofA bulls point to restructuring, digital efforts, and so on, but then again, what large U.S. banks aren’t making these moves too?
BAC’s Sector Is Overbought
The financials sector, as represented by the XLF ETF, is up from $19 in November 2016 to $26 now. From election night onward, banks have been trading virtually straight up. Admittedly, banks as a sector were probably undervalued prior to the election. However, a 35% move in the space of a year for an entire sector is still quite an amazing feat.
And it’s hard to pin the rally to many positive tangible developments for actual banking profits. Sure, the Fed has hiked rates a couple of times. But this has done little to improve banking profits. This is because the Fed primarily controls short-term interest rates. As such, they’ve followed the rate hikes and spiked higher. However, longer-term interest rates have been slower to follow.
The 2/10 year spread is an all-important metric for the banking sector. It measures the difference between short-term and long-term lending rates. When this spread expands, banks earn a fatter spread on the rates they charge for loans such as mortgages and the rates they pay on short-term deposits such as savings accounts and 1-year CDs. Immediately following the election, the 2/10 year spread expanded sharply. Since then, however, it has slowly trended back down, and has now lost all its gains of the past year.
This suggests that banks will not be any more profitable heading into 2018 than they were in 2016 on their primary source of income. Sure cost-cutting, expanded fees, and other ancillary profit drivers may help banking profits a bit. But none of these are sufficient to justify a 35% sector-wide rally.
Plenty of Sell: The News Events Ahead
The rally in banks, including the BAC stock price, has primarily focused on future upcoming events that will boost banking profits. For example, rising interest rates. However, as explained above, the Fed is not succeeding in its attempt to push up rates. They’ve lifted short-term rates, but it’s making a negligible impact on mortgage and other long-term lending rates. Thus, no juice for banking profits.
As such, the next Fed hike in December will be a disappointment. Bulls on BAC stock and other banks see the hike as a major catalyst. But if the last two rate hikes haven’t lifted net interest margins, why would this one be different?
Others were pointing to a new Fed chair pick as a potential tailwind for banks. However, the changeover from Janet Yellen to Jerome Powell is unlikely to make any waves. Trump made a choice that was safe and expected.
Finally, there is great excitement about the tax cut proposal. If the current proposal turns into law, Congress would slash the current corporate tax rate from 35% to 20%. This would be huge for the banks. However, look at forward earnings estimates for BAC stock and its peers, and they already suggest double-digit earnings growth. Much of this is from analysts already estimating lower 2018 tax rates. Thus, if a tax bill passes, it is already largely baked into BAC stock. And in the not unlikely event that the Republicans fail to pass legislation in this category, it’d likely lead to broad selling in banking shares as future assumed profits disappeared.
BAC Stock Verdict
BAC stock is up 125% in under two years. It was previously undervalued, but that ship sailed months ago. It has no clear edge on its top rivals that makes it a must-own stock. And its whole sector is running a little too hot at the moment. BAC stock is an easy sell.
At the time of this writing, the author held no positions in any of the aforementioned securities. You can reach him on Twitter at @irbezek.
