Renewed optimism from the Eurozone, in-line or better than expected domestic economic data, and solid third quarter performances all have contributed to a widespread rally in stocks. The BKX index (comprising 24 large-cap banks) was up 2.4 percent and the S&P 500 was up 1.1 percent for the week ending Oct. 21.
We believe that the banks can continue to display strong price performances as we witness thinning investment clouds related to the Eurozone, sustainability of the economic recovery, regulatory environment, and the mortgage mess. The industry should also benefit from a substantial underweighting of bank stocks in institutional portfolios, relatively low expectations, valuations well below historical levels, and loan loss reserve and capital levels near all-time highs. Once global fears lessen, we expect bank stocks to perform relatively well in a slow growth environment marked by gradually improving fundamentals and double-digit growth in earnings.
Quarter-to-date, all but one of the nation’s 40-largest banks (comprising our industry average) has posted gains, with 35 banks up more than 5.0 percent and our industry average up 11.4 percent. Thus far in fourth quarter, the BKX index has advanced 10.1 percent and the S&P 500 has risen 9.4 percent. In the third quarter, the BKX index was down 26.9 percent and 14.3 percent for the S&P 500. Second quarter 2011 earnings, encouraging as they may have been, were undermined by distressing macroeconomic, political, and regulatory headlines. The last time banks traded at these price levels was in July 2009, when we were also confronted with similar concerns. However, fundamentals have substantially improved over the past two years and the industry appears well positioned to withstand another economic downturn with relatively little pain.
Bank balance sheets have been fortified, capital and reserve levels are near all-time highs, the system is flooded with liquidity, the irrational players have been removed, and we have few accounting or regulatory rules to change. Granted, the implementation of Dodd-Frank will be a longer-term drag on profitability, but offsets and constructive changes are likely to follow a Republican victory in November 2012.
We are likely about two years away from normal profitability levels, and many banks trade at very attractive valuation levels with estimated double-digit growth rates for net income through 2013. Based on Street estimates (which have already been substantially adjusted for the very low interest rate environment), we expect our industry average to post earnings per share advances of more than 40 percent in 2011 and more than 25 percent in 2012. Yet, among the nation’s 40-largest banks, 27 trade below book value with the weighted average price-to-book ratio at 92 percent and the weighted average 2012 estimated price to earnings ratio at 9.6x (compared to about 150 percent and 12.5x, respectively, for our 15-year industry average).
Thus far in the third quarter earnings season, results have been highlighted by improved credit quality, accelerated growth in commercial loans, and increased mortgage banking income. Also, expense savings programs and balance sheet adjustments have become more prevalent as banks look to mitigate anticipated margin contraction from the current interest rate environment. Market-related revenue has been very weak (as expected) due to seasonality and market disruptions this quarter, but generally in-line or better-than-expected earnings per share has been driven by accelerating loan growth, strong mortgage banking gains, lower provision levels, and tighter control of operating expenses. However, the flattening of the yield curve and anemic balance sheet growth should continue to put downward pressure on the net interest margin (NIM).