What Could Make Bank Stocks Soar or Sputter in the Year Ahead

After a rocky year, bank valuations began to rebound in the fourth quarter of 2023, recovering to levels not seen since before March’s regional bank failures. That has many bankers and analysts feeling cautiously optimistic: Are we poised for higher valuations in 2024, or will it be more of the same?

Today’s valuations are being driven by a volatile cocktail of higher interest rates, credit-quality worries, regulatory uncertainty and other factors that are keeping many so-called “generalist” investors—fund managers, pension plans, wealthy individuals and the like that don’t specialize in banking—underweight on the sector.

In 2023, the Keefe Bruyette & Woods Bank Index declined 5.4% while the S&P 500 rose 24.2%.The average bank was trading at about 105% of tangible book value (TBV) and 8.5 times earnings—both near historical lows, but up from earlier in 2023—according to Mark Fitzgibbon, head of financial services research at Piper Sandler & Co. 

The stakes are high for bankers. Many have put capital raises, dividend hikes and M&A activity on hold while they wait for valuations to rebound, investment bankers say. For example, 2023 saw fewer than 100 acquisitions—a lower tally than during either the pandemic or the 2008 financial crisis, according to Chris Chapman, a managing director at the investment bank Janney Montgomery Scott. 

“There’s a tremendous sense of frustration among bankers,” Chapman says. “They feel optimistic about their operational outlooks, but it doesn’t mesh with their market valuations and there’s very little they can do about it.”

No one can say for sure what 2024 holds. An economic “soft landing” that cools inflation without sparking a significant recession could drive greater investor interest and a valuation surge. It’s also possible that a recession could dent demand for new loans and spawn asset-quality problems. Or that inflation could reignite, forcing the Fed to keep rates at elevated levels, or even hike them. 

“There are a lot of crosscurrents at play,” says Steve Moss, an analyst with Raymond James & Associates. “You can make the case for things to go really well for banks or really bad.” 

Winning Back the Generalists
During good times, generalists might devote about 20% of their portfolios to the financial sector, providing support for higher multiples. Today, investment bankers say, it’s often 10% or less. 

Luring back those generalists is important because the universe of bank-specific investors isn’t big enough to support a significant rebound. “The specialists can be really bullish on banks, but their purses aren’t big enough to offset the generalists [being underweight],” says Kirk Hovde, managing principal and head of investment banking with Hovde Group. “Bank valuations can’t recover without the generalists coming back.”

In recent months, bankers and analysts say they’ve been fielding more queries from generalists wanting to kick the tires on banks in anticipation of better times. “It doesn’t feel like they’re quite ready to pull the trigger and buy, but they’re starting to sniff around,” Fitzgibbon explains. “They think the likelihood of a soft landing is higher and are worried they’re going to miss out.”

Three Potential Scenarios
The market for publicly traded bank stocks sets the pace for valuations, trickling down to privately held banks. Those valuations move in relative unison, influenced mostly by things beyond the industry’s control. 

The coming year, with a contested general election, more geopolitical turmoil and other wildcards, promises to be especially intriguing. How might things play out? Below, we lay out three possible directions.

The base case is better than what bankers experienced in 2023 but still meh: The Fed cuts rates three, maybe four times in 2024, bringing short-term rates more in line with long rates, normalizing the yield curve. The benefits of those cuts are balanced by a modest recession that dents the repayment abilities of consumers and small businesses.

Bank valuations rise modestly, led by institutions that the public market perceives as having more resilient business models. “You have a mild recession, maybe a little stagflation, but it’s not the end of the world and you’re set for a rosier 2025,” Moss explains.

In the bull case, inflation rates decline and the economy slows gradually—but not enough to generate a meaningful recession. The Fed lowers rates as many as six times, and the yield curve takes on a more traditional look. 

Improving margins, stable asset quality and surging profits appeal to the generalists, driving valuations higher. “In that scenario, banks make more money and bank stocks go from the 8.5 times earnings they’re trading at today to 12 times earnings,” Fitzgibbon says. 

The bear case has several possible permutations, none of them encouraging. In one version, the Fed’s tightening overshoots its mark, and the resulting recession causes non-performers and charge-offs to rise in sensitive areas such as consumer lending and commercial real estate. “If you have to raise your loan-loss provision from 30 basis points to 80 or 90 basis points, your stock might drop 20% and your earnings could fall 40%,” says Jeff Davis, managing director at Mercer Capital.

Another variation sees the Fed cut rates early in the year only to begin raising them again because inflation re-emerges. “If they lower rates more than they should and it creates higher rates of inflation, it would whipsaw the market,” says Clint Stein, CEO of $52 billion-asset Columbia Banking System in Tacoma, Washington. 

Hope for the Best, Plan for the Worst
Which scenario is most likely? Analysts say narrowing spreads in both corporate bonds and leveraged loans portend a rally driven by rate cuts and a more normal yield curve, rather than the current inverted yield curve, which traditionally predicts a recession. “The market right now is telling us we’re going to get a soft landing,” Davis says. If that happens, “banks could attract more investors and earnings multiples could expand.”

Even so, Davis and others have trouble believing that the industry won’t face credit-quality issues if the economy slows. Even if lending margins expand, “no one will care because it will all be about credit losses and profitability,” Fitzgibbon says. 

In a market filled with both promise and uncertainty, smart banks can plan for all contingencies while continuing to fine-tune strategies and proactively tell their stories to investors. 

Columbia’s team meets quarterly with “targeted investors that are not current holders,” sharing and gathering feedback on everything from macroeconomic forecasts to deposit composition and pricing methodology, explains Jacquelynne Bohlen, Columbia’s investor relations director.

CEO Stein’s prediction for the coming year? “I think we get three rate cuts starting in May and by the fourth quarter they pause to see what happens.” That, he says, should help avoid a recession and drive bank profits and valuations closer to historical averages. 

“After what happened in 2023,” Stein says, “we should outperform.”