Every dog has its day. Among the stock market’s dogs the banks have been some of the mangiest, trading at a price-earnings ratio of less than 11 when the overall stock market trades at 17 times forward earnings. They were the worst-performing sector during the great crash of 2008, and that trauma remains prominent in the market’s collective memory.
In the past ten years, though, banks have shed an enormous amount of risk under the hard hand of the regulators. Rather than acting as risk-takers, the banks increasingly behave like a manufacturing industry providing a limited but reliable range of services, focused on reducing costs through automation.
Unlike the broad market, which flees from rising yields the way vampires shun the light of the sun, banks actually like rising rates, which boost their net interest margin. At the moment the S&P bank index (ETF ticker KBE) offers low risk, modest upside and a buffer against the possibility of rising bond yields.
Investors who own bonds or bond-like equities such as real estate investment trusts might consider banks as a hedge. KBE also will pay a 2.9% dividend yield this year, which makes it easy to own as a hedge.
During the bubble days of the mid-2000s, banks reported return to shareholders’ equity of 20% or close to it. They did it with smoke and mirrors. The smoke was structured products (collateralized debt obligations and the like) that bore dodgy AAA ratings but turned out to be junk when the crisis hit, and the mirrors consisted of leverage in excess of 60 times applied to AAA-rated assets. They got the rating agencies to assign a AAA label to Frankenstein derivatives that yielded cost of funds plus 30 basis points. Multiply that by 60, and you get 18% return on equity. That of course came to a bad end.
Today, banks’ return on equity clusters around the 11% mark. Most of the big banks are at 10%-12%.
That suggests that the banks are all doing the mediocre sort of business, and few can earn a high ROE because the regulators tie their hands. Investors value the big banks more or less the same, with the big banks trading at 11% to 12% return on equity.
Bank of America Chairman Brian Moynihan told a CNBC interviewer last week that he had laid off the equivalent of Delta Airlines’ entire headcount in the interests of efficiency. In fact, the recovery of return on equity among the banks from the abysmal levels after the crash depended to a great extent on increasing sales per employee by reducing the number of employees.
Banks are one of the sectors best disposed towards automation, artificial intelligence and other labor-saving applications. Having been a banker, I can think of very few (honest) things that bankers do that could not be done better by a computer.
Although banks have mediocre prospects for growth, they have good prospects to grow more efficiently. Risky businesses are less and less important to banks under the post-crisis regulatory regime. For that reason, I expect that the price-earnings ratio of banks to rise from its present average of less than 11% to 12%-13% over the next couple of years. I do not think it unreasonable to expect banks to return between 10% and 15% during the next year. If interest rates rise, banks will do better even while interest-sensitive stocks fall.
In this case, mediocrity and conformity are reassuring. Any time that banks do something imaginative, their shareholders will pay dearly for it.