Investors are shifting their focus to bank stocks as waning inflation signals the potential end of peak interest rates. The Federal Reserve's aggressive rate hikes aimed at combating inflation have resulted in a significant downturn in bonds this year. Consequently, lenders have faced immense pressure on their portfolios, leading to the failure of Silicon Valley Bank and others. As a result, financial stocks across the board have taken a hit, with the SPDR S&P Bank exchange-traded fund (ticker: KBE) experiencing a 13% drop so far this year.
However, the current tide seems to be turning as rapid disinflation takes center stage, causing traders to largely disregard the likelihood of further rate hikes from the Fed. Market forecasts even predict up to four rate cuts next year, potentially beginning as early as March. This is in contrast to central bankers' strong emphasis on the need to ensure that inflation is effectively kept under control.
The optimism surrounding bank stocks is already noticeable. The SPDR Bank ETF has seen a surge of over 13% during the first 14 trading days of November, marking the strongest start to a month since February 2021. Interestingly, in that very same February, the ETF rallied an additional 4.2%, followed by another significant gain of 9.2% in March. These figures suggest that the banks could be gaining momentum and are poised for further growth.
Nevertheless, not everyone shares this sentiment. Barry Knapp, founder of Ironsides Macroeconomics, believes that while falling inflation is a necessary condition for the Fed to shift its stance, weaker growth and a slowdown in the labor market are also vital indicators for rate cuts. Knapp speculates that these conditions may align in the first quarter of next year, as he predicts a one percentage point reduction in rates for 2024. However, he still believes it might be too early for this trade.
Knapp anticipates that bank stocks could be at the forefront of a broader downward movement in the market early next year before any potential rally occurs.
The Potential Upside for Bank Stocks
Some experts are feeling optimistic about the future of bank stocks. Gerard Cassidy, an analyst from RBC Capital Markets, believes that the recent halt in the Federal Reserve's interest rate hikes has given a boost to bank stocks compared to the broader S&P 500 index. Cassidy suggests that there could be a similar outcome to what happened in 1995 when bank stocks experienced a significant increase of over 50% following the end of the Fed's tightening cycle.
Additionally, bank stocks are currently trading at a cheap valuation of just 8.6 times their projected earnings for the next 12 months. This favorable valuation could also contribute to future price growth for bank stocks. Cassidy anticipates that if the Fed reaches its terminal interest rate in the near future, it could potentially result in further increases in bank stock prices, providing a rewarding opportunity for investors.
For those looking to capitalize on a potential rally, smaller banks may offer the most attractive options. Mark Fitzgibbon, an analyst from Piper Sandler, highlights that during the recent crisis in the banking sector, investors sought stability and safety by buying shares of larger institutions. This has left a group of well-managed, competitively priced small-cap banks overlooked and undervalued.
Fitzgibbon conducted a screening analysis and identified four smaller banks that stand out as potential winners: Brookline Bancorp (BRKL), Heritage Commerce (HTBK), Heritage Financial (HFWA), and Provident Financial Services (PFS). These banks meet specific criteria including being rated as overweight, having a market capitalization below $1.5 billion, offering a dividend yield above 4.5%, maintaining tangible common equity ratios exceeding 8%, and having dividend payout ratios below 65%.
However, it is important to note that investing in these smaller banks carries some risks, especially if the market misinterprets the actions of Federal Reserve Chairman Jerome Powell. If the Fed does not change its stance as expected, these smaller banks could face significant challenges. As Knapp warns, "If the Fed doesn't pivot, for whatever reason, then the small banks are gonna get bled."
As always, investors may prefer to stick with larger, more established banks for a sense of security.