MSR in the Media | Banks Have Vault-ed Ahead, but Should They Keep Investors' Interest?

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Banks have been enjoying excellent performance over the past year.

In fact, Wells Fargo (WFC) , JP Morgan (JPM) , Goldman Sachs (GS) , Bank of America (BAC) , and Morgan Stanley (MS) have each gained at least 70% over the year. Each of these track records more than double the returns offered by the S&P 500 at the same time. Meanwhile, many regional banks are also enjoying strong performance.

Despite the stellar track record, the sector's relatively modest valuation is encouraging added interest in a rally that may be ready to extend gains even further.

Intriguing Interest Rate Trend

Interest rates might be one of the keys to keeping the recent rally running.

At its meeting on Sept. 22, the Federal Open Market Committee hinted that a rate rise could be on the way next year as inflation concerns increase. According to the latest statement, half of the committee slated a rate hike for next year, with the potential for four rate hikes in 2023.

A team of analysts at Wedbush led by managing director of equity research Peter Winter advised clients that this is great news for bank stocks.

"The surge in deposit growth is mostly being held in excess cash on bank balance sheets given weak loan demand and an unfavorable rate environment," the team explained. "Thus, a steepening yield curve should drive stronger net interest income growth as banks will be more aggressive shifting excess cash earning just 15 basis points into either higher yielding securities and, hopefully, into even higher-yielding loans, leading to plenty of earnings leverage."

Considering the potential for multiple rate hikes, as forecast by a significant portion of the FOMC, the opportunity could be just at its opening stage for many bank stocks. Further, the capital ratios for many banks are the strongest they have been in years, adding stability in the face of any potential market turmoil.

Vetting Valuations

To be sure, not all are so enthusiastic about bank stocks.

"I do not share the growing optimism on bank stocks ("price has a way of changing sentiment")," Seabreeze Capital Partners President Doug Kass wrote in late September. "I don't see a new bull market leg in the space. Indeed, I see reward vs. risk deteriorating moderately in this week's advance."

The objection partially implied by Kass is that the recent run has already eclipsed much of the opportunity for bank stocks. For many investors, the recent run may also add questions about valuations.

However, in truth, the recent run has still not elevated the sector's valuations enough to perturb bullish investors.

"Looking at forward price-to-earnings multiples, the stocks are not overpriced relative to their history and the overall market," James Demmert, Managing Partner at Main Street Research, told Real Money. "As earnings grow and stock prices rise the price-to-earnings multiple will remain attractive. We would focus on banks with strong balance sheets, the big money center banks, as well as the regionals."

On the issue of regional banks, the team at Wedbush noted that they are particularly undervalued, trading at a P/E of 11.3 times their earnings estimates for 2022. They noted that this is an over 40% discount to the S&P, well below the historical average of about 20%.

Stock Selection

Still, while the overall industry is looking increasingly attractive, all banks are not equal. As such, careful stock selection is still a key issue for eager investors.

For Wedbush, which has homed in on the regional and mid-cap banks, the top picks were Fifth-Third Bank (FITB) , KeyBanc (KEY) , and Huntington Bancshares (HBAN) .

"FITB is seeing better growth than peers led by its specialty lending verticals and has little to no exposure to loan categories negatively impacting the group," the team noted, highlighting a top pick. "FITB has been one of the most disciplined banks not shifting excess cash into securities and waiting for higher rates."

On the issue of higher rates, the team added that Fifth Third is sitting on a $34 billion pile of cash, priming the bank's balance sheet to benefit the most among its peer group from potentially tighter Fed policy.

For large cap banks, the stock-picking is arguably more dicey.

Both Morgan Stanley and Wells Fargo have encountered issues, the latter relating to investigations and the former into merger integration. Each bank has received downgrades from analysts as of late, with Wells Fargo fueling the most caution given its near constant legal woes that are now eliciting increased attention from both Congress and the Fed.

While Elizabeth Warren's offensive against bank management is expected and unlikely to achieve the ends she desires, comments from Jay Powell should provoke more serious caution.

"We're of course very closely monitoring Wells Fargo's efforts to fix its widespread and pervasive problems," Powell said at the September FOMC meeting. "They represent a serious matter to us, and the firm is required to remediate them, and we will take appropriate supervisory action if the firm fails to meet our expectation."

For analysts, the confluence of regulatory risks are good enough reason to steer clear of the stock.

"The key concern from this issue is the perception that Wells harmed small businesses, which creates further political risk," JP Morgan analyst Vivek Juneja wrote in a note to clients. "In our view, the timing of lifting of the asset cap is likely to be much more impacted by the new consent order added earlier this month, Senator Warren's probes, and Gov. Powell's comments about expectations."

In the end, with the banking industry heading toward bullish market dynamics, the stocks that are more boring, are arguably the best options.