After latest quarterly results, our stock picker shares his analysis and opinion on the big American banks.
Banks are worth monitoring in any stock market as a reflection of the underlying economy and a leading indicator of sentiment.
In the US, they have strongly outperformed the S&P 500 index’s 16% rise during the first half of 2021, although second-quarter results reporting this last week has been mixed.
Pure investment banks such as Goldman Sachs Group Inc (NYSE:GS) have enjoyed record revenue and profit amid busy capital raising on the back of high stock prices, and record takeovers.
Equity trading has boomed, albeit off-setting declines from fixed-interest trading.
A mixed picture from the big “universal” banks
Demand for loans appears mixed, and banks also face a headwind of very low interest rates which compromises their business model.
Typically, like-for-like second-quarter revenues have turned out softer, however profits have massively beaten expectations because banks are “releasing reserves” – i.e. cash set aside a year ago to cope with an anticipated tide of loan defaults, which barely materialised due to huge fiscal/monetary stimulus.
Exceptional stimulus could mean transient prosperity
My overall interpretation is a glossy façade on some weak timbers below, even if it’s good to hear positive remarks on loan demand.
Admittedly, most valuations do not look extended in historic price/earnings (PE) terms, although yields are immaterial as a prop should stories change adversely.
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Charts show US bank stocks in a consolidation phase, which partly reflects renewed interest in technology and other growth stocks, hence an aspect of switching.
I suspect the extent of monetary and fiscal support from the US Federal Reserve and government has been axiomatic in all these banks avoiding big losses to instead report bumper profits.
If 5% US inflation does not abate later this year, stock market expectations will shift to tighter monetary policy – whatever Fed officials say in the meantime. Compared with UK-listed companies I have examined recently, US bank bosses are not forthcoming with firm guidance on 2021 profit as a whole.
Mind a latest sceptical study on “beating earnings estimates”
Coincidentally, with banks outstripping expectations this week, Bank of America Global Research released an interesting study, claiming the S&P 500’s rise this year has been wholly driven by raised earnings estimates.
Yet if history is any guide to future performance, 60% of down quarters in the US market have coincided with earnings beats.
In 2000, and despite beats for 10 successive quarters, stocks actually declined for four consecutive quarters.
That would also tie in with a longstanding adage about how stocks no longer responding to earnings beats implies a tired bull market.
Goldman and JP Morgan kick off with strong numbers
Helped by an investment banking bias, both banks beat revenue and earnings estimates, yet their stocks eased 1% or so. US merger and acquisition activity surged in April and especially May, providing a profits bonanza.
Goldman Sachs declared net profit of $5.5 billion (£4 billion) on $15.4 billion revenue – its second highest-ever numbers after a record first quarter – versus just $373 million profit like-for-like.
While return on equity eased below 24% after the first quarter, it was over 27% for the first-half-year.
I feel more positive about Goldman than other banks, given it enjoys top position globally for corporate finance and has stated its backlog had increased “significantly” since end-2020 – to a record level.
Barring losses on the trading side, this could easily keep Goldman’s numbers elevated for the rest of this year, in which case a trailing PE below 7x and 2% prospective yield mitigates risk of a slump in equity markets. At $373: Hold.
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JP Morgan Chase is on 12x earnings and likewise a 2% yield – albeit earnings per share (EPS) having enjoyed a $2.3 billion boost from reserves releases (linked to credit card and mortgage reserves).
The CEO says an improving US economic outlook drove this decision with consumer and wholesale balance sheets “exceptionally strong”.
Investment bank revenues were mixed, with trading revenue down 30%, offset by $3.4 million corporate finance revenue boosted by takeovers and their financing.
The stock eased 3% to about $156 having risen 24% this year. My instinct is to lock in gains, although the CEO is being positive on loans demand. Overall: Hold.
Bank of America underperforms the pack
This was the sole bank falling short of expectations, yet its shares eased only 3% to $39 – on a trailing PE of around 17x and prospective yield just over 2%.
Revenue slipped 4% to $21.6 billion chiefly due to a 6% fall in net interest income amid lower interest rates. Also, lower fixed income trading revenue of $2 billion was well below consensus, yet partly offset by better revenue from equities. EPS still trebled to over $1 after a $1.6 billion reserves release.
More positively, the CEO said its loan book grew in the second quarter for the first time since early 2020; but you could say that is priced in anyway given the stock has soared over 30% this year, nearly twice that of the S&P 500 index. Sell.
Citigroup and Wells Fargo out-perform
Citigroup beat revenue expectations, though was down 12% to $17.5 billion due to lower fixed income trading also credit cards loans, offset by equities trading and corporate finance.
A $1.1 billion reserves release meant EPS nearly quintupled however to $2.85 versus expectations for near $2.
The shares eased only very slightly to $68 having hit $80 in June, on an historic price earnings of 9x and prospective yield of 2%. Hold, albeit on a weak basis.
Wells Fargo & Co (NYSE:WFC) has seen revenue jump 10% to $20.3 billion, with EPS quadrupled to $1.4 versus near $1 expected – boosted by a $1.6 billion reserves release. Yet the CEO cautions: “demand for loans remains muted despite the economic recovery”.
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Wells’ stock rose 4% to $45 despite a very high PE – 31x historic – and a scant sub-1% yield, which combination has deterred me from advocating it.
Currently, it is in a sideways consolidation that remains below a $50 range during 2015 to 2018, but I would avoid it. Sell.
Morgan Stanley outperforms, similar to Goldman
Morgan Stanley (NYSE:MS) stock is flat at near $93 despite yesterday beating revenue estimates by 17% at $2.8 billion, with investment banking comprising 87% of this.
There is a similar pattern of equities compensating for a shortfall in fixed income trading, while corporate finance rakes in cash.
Morgan is also diversified in wealth/investment management – bolstered by acquisitions - which should help smooth earnings. Its asset management side is one of the largest globally, so if asset values remain supported the bank should do well and its stock is not expensive on a PE of 12 and 3% yield. Hold.
Federal Reserve’s response is the key issue going forward
Bank stocks are liable to pivot on whether US inflation proves transitory or ingrained later this year – with the risk of upsetting monetary policy expectations.
Rising interest rates would start to heal commercial banks’ operating model but strike a blow to equities – hence investment banking revenues.
Also, financial stocks do tend to be sensitive to overall changes in market sentiment. The risk/reward profile on US bank stocks therefore looks unfavourable.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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