The Future of Bank Stocks: A Possible Turnaround

Bank stocks have rarely been so despised. But the group's worst days appear to be in the rearview mirror.

The SPDR S&P Bank exchange-traded fund (ticker: KBE) is down 18% this year, while the S&P 500 is up 15%. In one way, the industry has never been as shunned as it is right now. The market value of all banks in the S&P 500 is less than 10% of the index's market value, an all-time low, according to Bank of America's investment research team.

Factors Behind the Weakness

The primary driver of this weakness has been the Federal Reserve's rate-hiking campaign. Central bank officials have significantly increased short-term interest rates, which has led to plummeting profit margins in lending businesses. These businesses rely on borrowing short-term money to make longer-term loans. Furthermore, depositors have withdrawn trillions of dollars from banks this year and redirected that money into higher-yielding money-market funds. Additionally, deal activity has decreased this year, posing a challenge for investment banks.

A Historical Perspective

Despite the current situation, the underperformance of bank stocks is unlikely to worsen based on historical trends. The previous low for banks as a percentage of the S&P 500's market value was in the late '80s. This was followed by a rally in bank stocks, outperforming the index throughout the '90s. Similarly, in the early 2000s, banks hit close to a new low before experiencing a rally that was cut short by the 2008-09 Financial Crisis.

A Potential Turnaround

For any turnaround to occur, it would require fuel, which may come from the Federal Reserve. There are indications that the Fed is nearing the end of its rate-hiking cycle. If the Fed decides to cut rates, it could result in a drop in the yield of the 2-year Treasury note, which is currently just below its multiyear high.

Lower short-term rates would have a positive impact on profit margins for loans. Bank stocks started underperforming in early 2021 when short-term rates began rising faster than long-term rates. In contrast, sinking short-term rates could bring about better performance in bank shares.

To be certain, the Federal Reserve might need to reduce interest rates due to a weakening economy. However, bank stocks have already priced in the possibility of economic turbulence. Once financial markets anticipate more substantial rate cuts, there is likely to be a positive shift in the outlook for loan demand, leading to an increase in bank stocks.

Loan demand plays a crucial role in this equation. Despite lower margins, banks have seen their revenue grow this year because they are able to charge higher interest rates. If there is continued stability in both consumer and business demand for loans even during an economic slowdown, loan volumes can remain stable. This scenario creates an ideal situation for bank revenue.

For instance, Bank of America (BAC) witnessed a 6% rise in revenue to $10.5 billion in the third quarter. This increase was driven by higher rates and a moderate rise in loan volumes. While loan volumes may weaken if the economy falters, a dip in interest rates could lead to a rebound in volumes as borrowing becomes more affordable.

Lower interest rates can also lead to a rebound in merger and acquisition activity. Buyers would find it easier to finance deals, while a stable economic outlook would support the profitability of buyout candidates. Considering Goldman Sachs (GS), its investment banking revenue is expected to have dropped by 14% this year but is projected to rebound to over $7 billion next year and surpass $8 billion by 2025, according to FactSet.

As the profit outlook improves, investors tend to assign higher multiples to earnings. Currently, the ETF trades at around eight times the expected earnings per share for the next 12 months, which is less than half of the S&P 500's multiple.

These positive developments in various areas should contribute to an increase in earnings per share (EPS) for the bank ETF. According to FactSet, EPS is expected to reach over $5 by 2025, exceeding the level of this year by more than 20 cents.

This potential upside appears promising.