Stockwatch: a strategy for active traders

US banks are potential ‘buys’ as the market starts to favour value and cyclical stock.

16th October 2020 12:11

by Edmond Jackson from interactive investor

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US banks are potential ‘buys’ as the market starts to favour value and cyclical stocks, argues our companies analyst.

US banks have kicked off third-quarter results reporting season with generally good numbers – given the circumstances – that affirm a sense that a “Covid trough” for the economy was reached in the second quarter of this year. Remember, this is what global advertiser WPP (LSE:WPP) first asserted in August.

A mixed economic narrative to decipher

Sentiment appeared jaundiced enough for the commercial bank stocks to initially fall as much as 5% on Wednesday following publication of results Tuesday night. Prices recovered 1-2% yesterday though. This may suggest some investors regard them as a means to play an anticipated Democrat sweep at the US election, which will pave the way for major fiscal stimulus.

Commercial bank shares anywhere are often a proxy for the wider economy. A current snag with this trader’s hunch is that ultra-low interest rates hurt their ability to earn a meaningful return on lending, simply to offset delinquent loans.

Yet compared with exorbitant US growth stocks, banks’ price/earnings (PE) ratios are not stretched, nor are their dividend yields debauched by excess price appreciation. Charts look to be in “wait-and-see” mode. It is therefore possible that traders do alight on bank stocks during the next month or so, according to sentiment towards the US economy. Bank of America, in particular, appears to affirm the sense of a V-shaped recovery.

Goldman Sachs and UBS have both advised clients to switch portfolios out of richly-valued growth plays, into cyclical/value, on the assumption Biden wins a Democratic sweep. We have been here in 2016 when pundits dismissed Trump, and Hilary Clinton did indeed win the popular vote, only for Trump to triumph via peculiarities of the US Electoral College.

Banks communicate cautious optimism

JPMorgan Chase (NYSE:JPM) and Citigroup (NYSE:C) reported initially on Tuesday, then Bank of America (NYSE:BAC) and Wells Fargo (NYSE:WFC) on Wednesday. They generally detect an improving economic outlook, hence are cautiously optimistic about recovery, though you might say that is pragmatic PR.

Operationally, there is a theme of falling net interest income from consumer and business loans, since the Federal Reserve lowered interest rates to near zero.

A total $5 billion provisions for loan losses across these banks has checked growth, yet they accumulated reserves during the early stage of the pandemic to withstand this. Recognising credit risk under Covid is made tricky because unprecedented stimulus has greatly mitigated delinquencies. Some people are actually earning more being unemployed, but banks remain concerned lest such people end up defaulting some time in 2021.

Their progress is thus strongly linked to how the US economy evolves. Listening to webinars, I hear a bull case for bank stocks if GDP can be 2-3% in the next two quarters, it being positive for credit demand.

Citigroup’s tone made for a cautious start on Tuesday

Citigroup shares fell 5% to below $44 after reporting a hike in costs and warning of slower economic recovery, over-shadowing profit that beat expectations. The story was further sullied by a $400 million regulatory fine relating to internal controls. At least the third quarter has shown stabilisation and net interest is expected to grow if Covid diminishes (take your own view).

Credit losses have been stable, but management sees them rising in 2021 and to peak towards the end of the year as stimulus effects wear off but unemployment stays high. Such is the cautious scenario, but Wall Street expects a strong Democratic majority view would renew support. Such concerns explain why, at around $44, Citigroup trades on a modest historic PE of 8.5x and a prospective yield of 4.7%.

By comparison, JPMorgan Chase (JPM) has an historic PE of 13.3x and prospective yield of 3.6% after it initially eased 2% to $101 in response to results, but it has strengthened to $102. It beat revenue expectations by 12% and earnings per share (EPS) by 24% - another example of operational gearing (mind that it works both ways).

Morgan does however enjoy an investment banking side that saw a 9% rise in fees, and the bank has strengthened its capital position. Outlook guidance was cautious however and, like Citigroup, was stung by a regulatory fine of $920 million.

US consumers have fully restored their spending

Bank of America (BAC) initially slid 5% after it reported a 16% decline in third-quarter profit to $5 billion, but claimed it is well prepared to weather any Covid recession. Like others, it has recovered some poise, to about $24, on a trailing PE of 11.9x and 3% prospective yield where earnings currently cover the dividend about twice.

Management reckons its data shows “a return to fundamentals of a generally sound underlying economy, but we won’t get there until we fully address the healthcare crisis and its associated effects”. They claim to have turned the quarter on Covid-related costs which should now reduce.

A V-shaped recovery is affirmed by the bank's analysts: the second quarter being the worst of the crisis with a 30% drop in GDP and consumer spending down sharply in April. However, stimulus and re-openings have swiftly triggered business recovery.

In the third quarter, consumers fully restored their spending which, at $2.3 trillion for the year to date, is actually up 10% on 2019. The US has already restored 90% of GDP. Bank deposits remain elevated and loan demand has stabilised.

Wells Fargo (WFC) seems forever the sector dog, reporting third-quarter profit down 56% and the expectation for a wave of soured loans. That its stock trades on an historic PE of 60x and yield of just 1.7% suggests the market is confident of recovery. Wells just seems to keep barking for the time I have followed it, so would tend to avoid the stock.

Investment banks are more a play on markets

Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) have declared bumper third-quarter results, with Goldman enjoying a 49% hike in fixed-income revenues and 71% in asset management. That was behind a 17.5% annualised return on equity, its highest quarterly return in a decade. This compares with 13% targeted by the CEO last January, demonstrating the extent to which investment banks are riding a wave of liquidity induced by the Federal Reserve. Morgan Stanley quite similarly beat analysts’ revenue estimates by $1 billion, up 16% like-for-like and, with the operational gearing typical of finance firms, achieved profit up 25%.

Yet despite these top names firing on all cylinders, their stocks have barely moved, even after beating forecasts. The market must wonder how sustainable these very strong numbers are; what might be the mean average outlook in a “whatever it takes” Fed policy era?

The dilemma for the risk/reward profile is that if these stocks do not respond usefully in as buoyant a period as now, why risk their downside potential should Covid drag on? You would not want to hold them through a bear market, though could still be candidates to buy for the turn if beaten down in a sell-off.

Widely ranging scenarios probably explain “compromise” ratings: Morgan’s trailing PE is 9x with its stock around $53, much lower than Goldman’s at 16x around $209. Forward yields compare at 2.8% and 2.4% respectively.

Chiefly rests on the economic outlook and dollar/sterling

Sentiment seems likely to remain volatile according to how the stimulus story pans out, progress with vaccines and the Covid situation globally. Yet bank stocks weathered yesterday’s US unemployment figures which were 8% worse than expected, the sector generally rising in a pressured market. This possibly reflects a more considered view after mark-downs initially in response to the results.

US bank shares are therefore a proxy for continued economic recovery, and any tactical switch into cyclical/value plays becoming more influential. As such, they are primarily for active traders attuned to events. A case exists to buy in small scale across Citigroup, JPMorgan Chase and Bank of America.

Sterling-based buyers do, however, need to weigh currency risks where there is now modest fear that a US dollar bear market is underway, albeit alongside the risk to sterling of a hard Brexit.

Buy.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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