What's Wrong with Banks?

Written By Briton Ryle

Posted February 8, 2016

If I had to point to one sector to demonstrate the pain of the current stock market sell-off, it would be financials. Bank stocks have gotten absolutely hammered.

Just one month ago, on January 4, Citi was a $51 stock. Today it’s $39. It’s down 23%. Goldman Sachs is down 15%. And you know it hurts me to see that Bank of America is down 22%…

Frankly, I’m surprised that Bank of America has fallen as far as it has. It has about the most Tier 1 capital of any U.S. bank. It’s about to get permission to increase its capital return plan for shareholders via dividends and share buybacks. It beat fourth-quarter earnings expectations handily, reporting $0.29 a share vs. $0.26 a share estimates.

BofA is on track to cut expenses by its stated $1 billion-a-year goal. It’s also about the cheapest bank in the U.S., trading at a huge discount to book value when compared to JP Morgan or Wells Fargo. (Wells Fargo trades at a book value of 1.4, JP Morgan is at 1 times book, while BofA trades at 0.6 times book value.)

In other words, the stability is there, the execution is there, the business is there, and the value is there. So what the heck is BofA stock doing trading back at 2013 levels?

The Curious Case of Bank Stocks and Recessions

Well, for starters, when the stock market is seeing big declines like it has, you start to see forced selling. That is, funds and insurance companies can sometimes be forced to sell stocks to raise cash needed for other things. The stock market is very liquid — that is, you can always sell stocks for cash immediately.

Plus, most days, BofA trades more shares than any other stock on the market. It is quite literally the most liquid stock out there. So BofA is going to sell off with the market — that’s pretty much a guarantee. 

But BofA shares are down a lot, much more than the market as a whole. And the reasons for it get a little complicated, so bear with me…

As you know, recent economic data has been so bad that there’s been a lot of talk of recession. Recessions are brutal on financial stocks because economic activity actually shrinks. That means fewer loans, fewer mergers and acquisitions, less spending, fewer bond sales, and so on — basically everything that a big bank like BofA does to make money.

Not only that, but what loans and such the bank is able to do are much less profitable because bond spreads get very tight. Let me explain that: A “spread” refers to the difference between the interest rates at which a bank can borrow and the rate at which it can lend. Usually, a bank can lend long term at a high rate and borrow short term at a low rate to fund operations, and the difference between the two is the bank’s profit.

The difference between long-term rates and short-term rates is expressed in what’s called the yield curve. When the yield curve is steep, it means spreads between long-term and short-term bonds is wide, and banks can make plenty of money.

But a funny thing happens when economies get weak and head into recession: the yield curve gets flat. That is, the spread between long- and short-term rates gets close together. And if an economy is going into recession, the yield curve will actually invert. That is, short-term rates will get higher than long-term rates.  

The reason for this is demand. When the economy gets dicey, investors (including big banks) need a safe place to put their money for a short period of time. They want short-dated Treasury bonds. That demand can push rates on short-term bonds higher. At the same time, when the economy gets dicey, investors expect the Fed to act to push long-term rates lower. That expectation will push real long-term rates on bonds lower. 

Clearly, if banks are lending long term at a lower rate than they can borrow short term, they could theoretically be losing money with every new loan they make. Not good.  

Now, inverted yield curves are highly correlated with recessions. And the scary thing is that we are very close to seeing the yield curve invert right now. Investors see that the yield curve is very flat, and they know it means bank earnings could change dramatically, so they are selling the stocks like there’s no tomorrow.

Is It a Recession? 

This is an important question. As I’ve written recently, manufacturing data has been very weak. In fact, the most recent ISM Manufacturing Index was in retraction territory (below 50). And many companies are announcing small CAPEX cuts.

On Friday, the employment report for January showed a gain of 150,000 jobs. This was a pretty good number, as it’s a bit better than the weak manufacturing data we’ve been seeing. 

What does it mean? Well, we will obviously need to see more data to be sure. However, it does suggest that the U.S. economy won’t slip into recession without a fight. 

We also need to get some clarity out of the Fed. That December rate hike just ahead of some really weak economic data has investors really spooked. Is the Fed totally out of touch with what’s going on? Or will economic data rebound sharply and validate the Fed’s actions? 

Quite honestly, I don’t know how it’s going to play out. But I do know that Bank of America — with a forward P/E of 7 and book value of 0.6 — is cheap. I suspect that there’s no need to rush out and buy it tomorrow, even if it rallies. Seems to me the issue of whether it’s a recession or not won’t be decided in the next day or two. 

But I will also say that if you bought BofA today or tomorrow, it is very likely to be higher in a year. Maybe not next week or next month, but the day will come when BofA is worth more than $13 a share. And frankly, in a better economic environment, BofA could be a $23 stock.

Bank of America is a core long-term holding for my Wealth Advisory income and dividend newsletter. I have no intention of selling it.

Until next time,

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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