US bank stocks may be too hot with earnings season nearing

HONG KONG (BLOOMBERG) – Bank stocks have been one of the best trades of this year, and with third-quarter earnings set to kick off on Wednesday (Oct 13) analysts expect the industry to show continued strength. The question for the shares, however, is how hot is too hot?

The KBW Bank Index has surged almost 40 per cent this year, more than doubling the broader S&P 500 Index’s 17 per cent gain, as investors keep buying lenders amid growing expectations that a United States economic recovery will spur the Federal Reserve to scale back is massive asset purchase program and eventually begin raising interest rates.

“It’s hard to be too negative on the banks given a generally favourable macroeconomic outlook among most and the prospect for higher rates and faster loan growth,” Deutsche Bank analyst Matt O’Connor wrote in a Sept 30 note to clients.

This anticipation reached a fever pitch following the Federal Open Market Committee’s Sept 22 policy decision, when chairman Jerome Powell said the central bank may start its long-awaited tapering soon. All 24 members of the KBW Bank Index have climbed at least 4.6 per cent since then, with three-quarters of them rising 10 per cent or more.

Despite the strong performance by banks through the first nine months of the year, many analysts are not wavering in their bullish outlooks, believing that the environment is right for these stocks to keep running. Last month, Keefe Bruyette & Woods analysts upgraded the entire US banking sector to overweight, saying an inflection in loan growth, higher interest rates and the redeployment of cash should bolster earnings.

That sentiment was echoed by RBC Capital Markets analyst Gerard Cassidy, who said bank shares should continue to push higher over the next year – barring a double-dip recession. “Investors who believe that the economy will continue to expand, especially as supply chain disruptions are resolved and inventories are rebuilt, should look to own banks stocks,” he said.

That isn’t to say everyone agrees. Indeed, the current debate on Wall Street is whether banks are priced too close to perfection.

“Big US banks are trading rich,” BMO Capital Markets analyst James Fotheringham said. He suggests investors look to take profits as JPMorgan Chase – which kicks off the earnings party Wednesday morning – and Bank of America have soared above historical averages.

Morgan Stanley shares have also come under fire recently after surging nearly 54 per cent this year through late August, when they touched a record high. The bank was hit with downgrades on back-to-back days late last month, with analysts at Oppenheimer and Berenberg both citing valuation concerns as the reasoning behind their cuts.

This is not the case in Europe, where banks are this year’s top-performing sector this year, yet the shares remain historically cheap. Trading at nine times forward earnings, banks are the third-cheapest sector in the Stoxx 600 Index and trade at a roughly 40 per cent discount to the broad benchmark.

And to be sure, not everyone is worried about US banks’ elevated multiples. Baird’s David George and Goldman Sachs analysts agree that while valuations are elevated compared to historical norms, they still look attractive when compared with the broader market.

While the week’s results should help start to settle the debate around valuations, investors may already be turning their attention elsewhere. “The third quarter numbers themselves should be relatively boring and bland,” said Vital Knowledge founder Adam Crisafulli. “The bulk of the near-term price action will be based on Treasuries and macro forces along with capital returns and Fed staffing.”

Here is a look at where the big six US bank stocks stand as they head into third-quarter earnings next week:

JPMorgan Chase

The bank will kick off the reporting season on Wednesday morning with its shares having surged 34 per cent this year, including 11 per cent since the Fed’s Sept 22 policy meeting. The run-up has narrowed the gap with analysts’ 12-month target price to less than 1 per cent. It has 19 buy ratings, but its three sell ratings are the most among the six biggest banks.

Bank of America

The bank is expected to be the first in a flurry of releases Thursday morning. The shares have climbed 46 per cent this year, outpacing analyst price targets and leaving it with an implied return of -1.2 per cent over the next 12 months. Wolfe Research analyst recently downgraded the stock to peer-perform from outperform, citing concerns about its valuation.

Wells Fargo

Wells Fargo reports on Thursday, and while its shares remain well below pre-pandemic levels their 59 per cent return this year makes Wells the best performing big bank this year. Nearly half the analysts who cover it have the equivalent of a hold rating, though their average 12-month price target is 5.9 per cent above its Friday closing level.

Morgan Stanley

Shares are up 46 per cent this year and are just shy of their August record high ahead of its Thursday release. Oppenheimer and Berenberg cut their ratings on the stock to hold-equivalents. Still, its 21 buy ratings are the most among the big six banks.

Citigroup

Citi will cap off Thursday’s bank earnings deluge. The stock is up 17 per cent this year, by far the worst for the group. Still, analysts have maintained their price targets and see 14 per cent in return potential over the next 12 months. The lender is tied for the second-most buy-equivalent ratings in the group and is one of only two of the big six banks to not have any sell ratings.

Goldman Sachs Group

Goldman releases its earnings Friday morning. The stock has climbed 49 per cent so far this year, making it the group’s second-best performer. Analysts have steadily raised their price targets amid the rally and see an additional 8.1 per cent in upside over the next year, trailing only Citi’s return potential.

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