There are multiple reasons why the financial services sector is scuffling this year. Bank of America (NYSE:BAC) isn’t immune to that trend. Year-to-date, BAC stock is off about 27% while the S&P 500 is up 3.53%.
Low interest rates alone, something BAC stock was contending with entering 2020, are a drag on bank equities because those low rates suppress banks’ net interest margins. That’s the spread on loans made by lenders and what’s paid out in interest to depositors. For those that prefer a simpler explanation, financial services is one sector that historically performs well when the Federal Reserve is tightening, not easing.
Further plaguing the sector is the reason why the Fed took rates to near-zero. The culprit is, of course, the novel coronavirus pandemic. The U.S. economy rapidly deteriorated in the first quarter, prompting the Fed to move rates to historic lows. The rock-bottom rates were bad enough for bank stocks, but the slack economy was worse because it forced banks to set aside more cash to cover bad loans.
In the first quarter, Bank of America allocated $4.76 billion to cover sour loans, the company’s highest total for that use in a decade. That figure rose to $5 billion in the June quarter.
There’s Hope for BAC Stock
Throw in the fact that earlier this year, the Fed told banks to hold off on boosting dividends and forced a halt on buybacks, and it’s easy to see why investors are frustrated with big banks. Fortunately, there’s light at the end of the tunnel with Bank of America.
The bank’s second-quarter loan loss provision, while modestly higher than the first-quarter level, was well below the increases at rivals JPMorgan (NYSE:JPM) and Wells Fargo (NYSE:WFC). Specific to the latter, it’s clear that over the near- to medium-term Bank of America is the superior choice for investors. Those that need some convincing to that effect should consider that Warren Buffett’s Berkshire Hathaway (NYSE:BRK.A, NYSE:BRK.B) is slashing its Wells Fargo stake while boosting exposure to BAC.
Second, there are indications that the amount of cash devoted to bad loans peaked in the second quarter. Many banks were overly prudent in building those reserves in the first six months of 2020. That’s important because if the economy improves and loan loss rates aren’t as bad as previously expected, financial firms like of Bank of America can convert the unused portion of those reserves into earnings.
In other words, Bank of America has some earnings firepower sitting on the sidelines and it could be deployed sooner than expected.
Patience Required
Investors considering bank stocks today need to be clear on a crucial factor: the Fed is making clear that interest rates are unlikely to rise prior to 2023. So the higher rate catalyst is off the table for years to come for this sector.
That means the wager investors are placing with Bank of America isn’t based as much on monetary policy as it is a bet on the U.S. economy. As the jobless rate and Covid-19 case and fatality counts decline, bank stocks should benefit, particularly if the companies can convert loan loss reserves into earnings.
It’s further out, but in a hypothetical scenario where a coronavirus vaccine is accessible and jobs are being restored to the point that the unemployment rate is cut in half, the Fed could consider allowing Bank of America and friends to increase shareholder rewards.
In the meantime, investors don’t have to pay up to be involved with Bank of America, because deep into the second quarter, more than half the banks in this country traded below tangible book value.
On the date of publication, Todd Shriber did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.
Todd Shriber has been an InvestorPlace contributor since 2014.
