Why Investors Should Consider Bank Stocks (KWBW)

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June 24, 2017 7:20am NASDAQ:KBWB

NASDAQ:KBWB | News, Ratings, and Charts

From Invesco: Bank stocks have spun their wheels for most of 2017. Year to date through June 9, the KBW Bank Index (BKX) had risen 3.03% compared to 9.61% for the S&P 500 Index.

Banks fizzled as the reflation trade faded and the outlook for fiscal stimulus and meaningful regulatory changes was delayed by the political situation in Washington, DC. However, I believe the banking industry may warrant another look for three reasons:

1. Banks are still inexpensive, while regulation may be slowly loosening

Large banks remain inexpensive in a market focusing more closely on stretched valuations. Although a return to the pre-financial crisis valuation high is not expected, the BKX was trading at 1.76x tangible book value in the week ended June 9, and had recently crossed above the post-financial crisis highs before settling back to hold the old highs established between 2014 and 2015.1 It has been trading at a near 50% discount to its pre-financial crisis price-to-tangible-book ratio of 3.51.1 In contrast, the S&P 500 Index was trading at 8.78x tangible book value and trading 35.6% above the Oct. 2007 pre-financial crisis valuation high.1

KBW Bank Index, price to tangible book value

Weekly data, Jan. 9, 2004, to June 9, 2017

KBW Price Index

Source: Bloomberg L.P. as of June 9, 2017. The gray line from 2013 onward illustrates that the index has recently risen above its previous highs.

There is a chance for bank valuations to expand as the regulatory environment eases. The Treasury Department’s banking regulation plan released June 12 appeared to be well-received by Wall Street analysts, stoking hopes that banks might be able to more efficiently utilize their balance sheets and improve returns on capital. Moreover, the Treasury Department’s plan came on the heels of the House of Representatives passing the Financial CHOICE Act, which is a roll back of the Dodd-Frank financial regulations.

The BKX’s return on equity was about 8.5%, on June 9, 2017, compared to a peak just over 16.0% in February 2007 prior to the crisis.1 A return to 2007 return on equity levels is unlikely, in my view, but I see room for expansion in a looser regulatory environment.

2. Loan growth may be bottoming

One headwind to banking sector returns has been a slowdown in lending. Some of the weaker growth is related to tough year-ago comparisons, but a second factor is a function of weaker economic activity in 2015 and early 2016.

Loan growth was occurring at a double-digit pace in the first half of 2016 before tailing off and recently marking a lull of just 2% year-over-year in May.1 As 2017 progresses, I expect those year-over-year comparisons to look more favorable and help support the growth rate. More importantly, history suggests that the ISM Manufacturing Index can lead loan growth by roughly one year, as shown in the chart below. The index hit a relative low in August 2016 at 49.6 and rose to a recent peak of 57.7 in February 2017 before trending sideways to slightly lower in recent months.

Manufacturing activity has led loan growth by about a year

ISM Manufacturing Index plus one year, versus US commercial bank loans and leases, and commercial and industrial loans

ISM vs Loan Growth

Source: Bloomberg L.P. as of May 31, 2017. Loans represented by US commercial bank loans and leases, and commercial and industrial loans, as defined by the US Federal Reserve.

3. Mean revision in Treasury market volatility could potentially improve trading profits:

Volatility in the Treasury market, measured by standard deviation, has been historically low and a drag on trading profits. As shown below, the Merrill Lynch Option Volatility Estimate (MOVE) Index finished the week ended June 9 at 52.55. It has seen these levels just 1.4% of the time on a weekly closing basis since Jan. 5, 1990.1

The Merrill Lynch Option Volatility Estimate Index has recently traded near historical lows

Option volatility

Source: Bloomberg L.P. as of June 9, 2017

On May 31, both JP Morgan Chase and Bank America noted that second-quarter trading revenues would be hurt by calm markets. A lift in volatility is possible not only on a mean reversion basis, but as the debate over the Federal Reserve unwinding its balance sheet heats up and the European Central Bank looks to end its quantitative easing program with signs of improved economic growth in Europe.1 Additionally, over the past 20 years, there has been a positive relationship between increased Treasury market volatility and rising 10-year Treasury yields.2 Bank shares tend to display strength during periods of rising interest rates.3

A risk to watch

One risk to the value factor and higher bank valuations may rest in low inflation. The Consumer Price Index excluding food and energy has declined from a recent year-over-year peak of 2.3% to 1.7% in May.1 The decline has been driven by motor vehicles, apparel, and household furnishings and operations. Low inflation is a dynamic that could cap long-term interest rates and flatten the yield, while suppressing excitement over a reflation trade.

ETFs of interest

Investors interested in exposure to banks may want to explore the PowerShares KBW Bank Portfolio (KBWB) or examine the PowerShares S&P 500 Value Portfolio (SPVU). SPVU has nearly 23% exposure to banks and nearly 40% exposure to financial shares as of June 14, 2017.

The PowerShares KBW Bank Portfolio (NASDAQ:KBWB) closed at $47.18 on Friday, down $-0.38 (-0.80%). Year-to-date, KBWB has declined -0.19%, versus a 8.77% rise in the benchmark S&P 500 index during the same period.

KBWB currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #7 of 39 ETFs in the Financial Equities ETFs category.

1 Source: Bloomberg L.P., data as of June 9, 2017

2 Source: Bloomberg L.P., data from June 14, 1997, to June 13, 2017. The correlation between Treasury volatility (the MOVE Index) and the 10-year Treasury yield was 0.19, and the beta of a regression was 0.09, with a t-test of 6.26.

2 Source: Bloomberg L.P., data from June 14, 1997, to June 13, 2017. The correlation between bank stocks (BKX Index) and the 10-year Treasury yield was 0.297, and the beta of a regression was 0.32, with a t-test of 10.03.

Important information

Blog header image: Who is Danny/Shutterstock.com

Past performance is not a guarantee of future results.

The KBW Bank Index is a float-adjusted, modified-market-capitalization-weighted index that seeks to reflect the performance of publicly traded companies that do business as banks or thrifts in the US. An investment cannot be made into an index.

Correlation is the degree to which two investments have historically moved in relation to each other.

Reflation refers to a monetary policy intended to curb the effects of deflation. The reflation trade refers to the practice of investors looking to buy value and cyclical stocks in an effort to benefit from periods of strengthening economic growth, rising inflationary pressures and increasing interest rates.

Tangible book value is a company’s total assets minus liabilities and intangible assets.

Price-to-tangible-book ratio compares a company’s stock price with its tangible book value.

Return on equity (ROE) is a measure of profitability, calculated as net income as a percentage of shareholders’ equity.

The ISM Manufacturing Index, which is based on Institute of Supply Management surveys of more than 300 manufacturing firms, monitors employment, production inventories, new orders and supplier deliveries.

The Consumer Price Index measures change in consumer prices as determined by the US Bureau of Labor Statistics.

Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time.

Standard deviation measures a portfolio’s or index’s range of total returns in comparison to the mean.

T-test: After an estimation of a coefficient, the t-statistic for that coefficient is the ratio of the coefficient to its standard error. That can be tested against a t distribution to determine how probable it is that the true value of the coefficient is really zero. A value over the absolute value of 2.0 is seen as statistically significant.

Regression is a statistical measure that attempts to determine the strength of the relationship between one dependent variable and a series of other changing variables. Regression helps investment and financial managers to value assets and understand the relationships between variables.

The Merrill Lynch Option Volatility Estimate (MOVE) Index is a yield curve weighted index of normalized implied volatility on one-month Treasury options.

There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The fund’s return may not match the return of the Underlying Index. The fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the fund.

Investments focused in a particular industry, such as banking, are subject to greater risk and are more greatly impacted by market volatility, than more diversified investments.

The funds are non-diversified and may experience greater volatility than a more diversified investment.

A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.

This article is brought to you courtesy of Invesco.

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