Why Your Hatred of U.S. Bank Stocks May Prove Misguided

Shares of banks have been conspicuously absent from the second-quarter rally in U.S. stocks, adding drama to the mystery of where interest rates are heading next.

The Standard & Poor’s 500 Banks Index has slumped 4.4 percent since the end of March, the biggest loss of only four groups to retreat among 24 industries in the benchmark gauge. The S&P 500 as a whole is up 2.7 percent over the same period.

The divergence in performance created some eye-popping valuation discounts. At the start of today’s session, bank share prices were 1.05 times book value compared with a multiple of 2.7 for the S&P 500, marking the biggest spread since 2000. At 10.9 times trailing earnings, lenders are the cheapest compared with the S&P 500 since 2004.

So are bank shares a screaming buy or is the rest of the market missing something? Unfortunately, this is where the markets start to resemble a Dan Brown novel because there is an even bigger mystery embedded in the valuation riddle: Why have longer-duration benchmark Treasury yields defied expectations by falling as the Federal Reserve unwinds its bond-purchases?

For sure, there are many factors that affect bank stocks, including the seemingly never-ending stream of legal woes they face. But the spread between short-term and long-term interest rates is one of the simplest and hardest to ignore. Banks tend to borrow money at short-term rates and lend at long-term rates.

Yield Curve

Consider, then, the spread, or yield curve, between two-year and 10-year Treasuries. It narrowed to less than 210 basis points, or 2.1 percentage point, at the end of May from 230 basis points at the end of March and 264 points at the end of 2013. Bank earnings are forecast by analysts to contract 1.1 percent this year before jumping 14 percent next year.

With U.S. economic growth forecast to reach at least 3 percent this quarter and the following four, either the bond market or the economists making growth predictions are wrong, according to Wunderlich Securities analyst Kevin Reynolds. He predicted in a report today that economists are likely right, citing strengthening private payrolls, improving housing, early signs of inflation and strengthening loan demand.

The backdrop provides “a bullish fundamental outlook for spread-based community and regional banks operating in economically vibrant local markets,” Reynolds wrote. His top picks include small-cap stocks Home BancShares Inc., BancorpSouth Inc., Renasant Corp. and CenterState Banks Inc.

17 Percent

And what if the bond market is right? Piper Jaffray Cos. technical analyst Craig Johnson wrote in note that the drop in 10-year yields is “not a bullish sign for the economy” and could signal short-term losses for the market. Coupled with underperformance by shares of smaller companies, a drop of as much as 17 percent in the S&P 500 could be in the cards, Johnson wrote.

The yield curve has risen for three days after reaching an almost one-year low on May 28. This week may bring clarity on where it’s headed as the European Central Bank makes policy decisions on June 5 and the U.S. government reports employment numbers the next day. If the yield curve goes any lower, banks may have to start giving toasters out to shareholders.

Before it's here, it's on the Bloomberg Terminal.