Bernstein Predicts Bull Market for U.S. Bank Stocks

U.S. bank stocks have been on a tear over the past few months, thanks to a spell of rising bond yields. Analysts at Bernstein say the party could continue.

So far this year, the KBW Bank Index has outperformed the S&P 500 by around 460 basis points. The outperformance has occurred only since late April, when U.S. Treasury yields began to rise off the back of positive economic data.

In a note published Tuesday, Bernstein looked at nine large-cap U.S. banks; Bank of America Corp., BB&T Corp.BBT +0.50%, Citigroup Inc.C +0.57%, J.P. Morgan Chase JPM +0.61% & Co., PNC Financial Services Group Inc.PNC +0.94%, Regions Financial Corp.RF +0.79%, SunTrust Banks Inc.STI +0.93%, U.S. Bancorp, and Wells Fargo WFC +0.23% & Co.

Bernstein’s two best picks are Citi and J.P. Morgan, thanks to a combination of low valuations, trading exposure and dividend yields. However, the note predicts a bull market across the large cap sector, resting on three key points:

Rising rates are beneficial for bank stocks

While investors wait for the Federal Reserve to increase rates, they have spent much of their time wondering how the market will react. For Bernstein, this doesn’t matter.

If the market sells off, banks will hold up well “given market expectations regarding their asset sensitivity.” If a bank is asset sensitive, a rise in rates benefits its assets more than it impacts its liabilities.

And if the market rises – as investors take a rate increase as a sign of a healthy economy – banks are a good play on an improving economy.

Unlike rival sectors, profit margins at banks not at their peak

Banks are still trailing their average profitability levels. Over the first quarter of 2015, their return on assets reached 1.05%, below a pre-2008 average of 1.34%.

In comparison the net profit margin – the percentage of revenue after costs – of the S&P 500 is at 8.5%, just down from an all-time high of 9%.

While Bernstein admits that banks are no longer the profit engines of the past, thanks to regulation and compliance, there is still some headroom for profit margins to improve.

Bank valuations are in line with historical averages, unlike S&P 500

Large-cap bank stocks are trading at 12.4x forward earnings, compared to an historical median of 12.2x. However the S&P500 is trading at 17.6x forward earnings, which Bernstein points out is a significant 10-12% premium to its long-term median. If banks become more profitable thanks to rising rates, then the market might recognize that banks are undervalued.

Bernstein admits there are risks. Rates may not rise, and banks may not be as asset sensitive as they believe they are. However, the note concludes that: “Overall we think there is a credible case for the large-cap banks to outperform over the near- to intermediate-term as the interest rate environment normalizes and the broader market reacts to higher rates.”