On Oct. 30, the Federal Reserve cut interest rates by 25 basis points. The expected move came amid concerns about trade wars and a potential economic slow down globally. Yet Fed officials were divided about the decision. Variables such as interest rates, economic growth, global political and trade worries and activity in the housing markets can impact a bank’s stock price. Therefore, today I’d like to discuss the outlook for Bank of America (NYSE:BAC), one of the largest banks globally.
Year to date, BAC shares are up over 33%.
Our readers may remember that it is now Berkshire Hathaway’s (NYSE:BRK.A, NYSE:BRK.B) second-largest holding. Although I believe Bank of America stock should belong to a long-term diversified portfolio, I expect market volatility and some profit taking in the short run. In case of a pullback in BAC stock in the coming days, investors may consider buying into Bank of America shares on the dip.
Bank of America Stock and the U.S. Economy
The outlook given by Bank of America as well as CEOs of other major corporations in recent months shows that the economic or banking cycle in the U.S. isn’t at its most attractive point. Our economy had fired on almost all cylinders for a number of years. Now it may be poised to glide onto a slower growth trajectory.
Bank stocks are exposed to economic ebb and flow. If you are considering buying banking stocks, it’d be important to remember that two main factors affect a bank’s revenue and earnings:
- Interest rates: As interest rates increase, a bank can earn more money from its loan portfolio.
- Economic activity outlook: In a robust economy, more money circulates through the system, fueling a bank’s non-interest income.
In short, if the U.S. economy cools down in the coming months, Bank of America stock is likely to be adversely affected. Despite the potential economic headwinds, it is not quite possible to know if or when we will enter a recession in the coming quarters.
Interest Rates and BAC Stock
Bank of America stock’s income is divided into two main categories: net interest income (NII) and non-interest income.
Like other banks, BAC stock earns income on loans and other interest-earning assets. It pays interest on deposits and other interest-bearing liabilities. We can arrive at the bank’s net interest income by deducting interest paid from the total interest earned.
Recent research by Lindsey Gallo of University of Michigan, Rebecca Hann at the University of Maryland, and Congcong Li at the Singapore Management University, highlights that “The Federal Open Market Committee (FOMC) is responsible for setting the Federal funds target rate … When economic data are stronger (weaker) than expected, the FOMC is likely to increase (decrease) the target rate … [T]he stock market reacts negatively (positively) to unexpected increases (decreases) in the target rate.”
In general, decreasing interest rates mean headwinds for banks, including Bank of America as lower interest rates put pressure on NII and margins.
Several of our readers may remember that earlier in July, Bank of America had cut its NII growth outlook to 2% in a stable interest rate environment. Since the release of Q2 earnings in July, we have had three Fed rate cuts, one in late July, one in September and one in October.
At present, the Fed’s rate-hike cycle is likely to be over. Therefore, the potential effect of theses recent Fed cuts are likely to be factored in the stock price of Bank of America.
However, in the coming months, if there is another rate cut, then BAC stock’s earnings from loans could suffer and affect the share price.
How Bank of America Stock’s Q3 Earnings Came
Net income rose 4% to $7.5 billion, or an adjusted 75 cents a share, excluding an impairment charge.
Four separate divisions contribute to Bank of America stock’s revenue:
- Consumer Banking,
- Global Wealth and Investment Management,
- Global Banking, and
- Global Markets.
Other than Global Markets, three divisions reported gains in revenue, led by Bank of America’s Global Banking segment, which brought in impressive investment banking fees.
Overall, credit growth, higher deposits and increased investment banking fees supported BAC stock’s third-quarter earnings. CEO Brian Moynihan has highlighted that the group has been working to add value for its customers while also keeping various costs down. As I analyse the results, I note a diversified revenue stream, solid balance sheet and capable management team.
Research by Yabshi Pan Rinzinwangmo, Song Fengming, and Peter Flavel published in the Thunderbird International Business Review concludes that a “long‐term, durable, and well‐executed corporate strategy is essential for any banking institution working to build a world‐class financial firm.”
Therefore, I believe that Bank of America is likely to outperform the market in the medium to long term.
BAC Stock Has Attractive Valuation Levels
In the U.S., the Bank of America serves about 66 million consumers and small business clients, giving the bank an attractive deposit base. It has over 4,350 retail financial centers and plans to increase that number in the coming quarters. The group’s online and mobile banking operations are also growing fast, adding to increased fees charged for banking activities.
Due to extensive expense management measures over the past several years, Bank of America’s efficiency ratio has improved (i.e., gone down). It now stands at 57%. For the Consumer Banking section, the ratio is an impressive 45%.
A decrease in the ratio means that the bank has incurred lower costs to generate every dollar of income. For banks, the objective is to get the efficiency ratio as close to 50% as possible. This respectable overall number by BAC shows how effective management’s cost-cutting initiatives have been.
The efficiency ratio is calculated by dividing the BAC’s non-interest expenses by its net revenue. Non-interest expenses may include personnel salaries and other related expenses, marketing costs and real estate rent, among others.
Furthermore, the forward P/E ratio for BAC stock stands at an attractive 12.1. And value investors may be interested to know that its annual price-to-book (P/B) ratio is 1.31.
P/B ratio is used widely to value for asset-heavy companies, such as banks or other financial institutions. In general, for banking stocks, a number below 2 could imply good long-term value. However, investors should do their due diligence by looking at other metrics, too.
Where the BAC Stock Price Is Now
Year to date, Bank of America stock is up over 33%. Prior to the earnings report of Oct. 16, BAC stock had been trading in a range, between about $26 and $31. Since then, on Nov. 7 it has made a new 52-week high at $33.6.
The share price is now hovering around $33, where there seems to be resist ance building from a technical point of view. If Bank of America stock cannot go and stay over the $33 level soon, there will likely be profit taking in the stock. Then, I’d expect the stock to fall toward the $30 level, where it will find initial support.
I would not advocate bottom-picking in case of near-term price weakness. Yet, I find Bank of America stock to be a buy candidate if the price declines toward $30 or even lower. If BAC shares can build up momentum, then investors are likely to push to price to a new high in the last quarter of the year. By the end of 2020, long-term investors may indeed see the price reach $36-$37.
Meanwhile, BAC shareholders can also enjoy a current dividend yield of about 2.2%. The shares are expected to go ex-dividend on Dec. 5. Management also continues to buy back shares, which supports Bank of America stock price.
The Bottom Line on BAC Stock
In the coming weeks, BAC stock, like many other stocks in the broader market, is likely to be impacted by the rhetoric of the U.S.-China trade wars as well as global growth worries. Therefore, I expect some volatility in the share price as well as possible profit taking. However, long-term investors may consider buying the dips in BAC shares.
As of this writing, Tezcan Gecgil did not hold a position in any of the aforementioned securities.