Is Lower Better for Bank Stocks?

The air has come out of bank stock prices, and that may actually be a relief for bank executives.

Some of the hot money that flooded into bank stocks earlier this year on expectations of rising interest rates has found the exits, but banks' underlying earnings potential has not really changed.

That reality makes bank stocks more attractive to value-based investors turned off by the frothy prices early this year, and it could relieve banks of the pressure to hit overly bullish earnings targets.

"Anything that rids the sector of momentum investors that have been indiscriminately buying bank stocks simply because 'rates are rising' … could actually be a good thing for value investors," wrote Keefe, Bruyette & Woods' Chris Mutascio in a note this week. "It better aligns valuations with actual fundamental performance."

Bank of America was the first to see the silver lining emerge when it received a handful of analyst upgrades earlier this week.

KBW analysts made a similar argument for Citigroup on Friday, arguing in a note that the sell-off "has created a unique buying opportunity to own a franchise that is expected to successfully complete a restructuring plan and improve returns over time."

The key to this line of argument is believing that the underlying drivers of banks' profit are little different than before the markets started falling. Banks' stock prices, on the other hand, have priced in the expectation of an extended worldwide slowdown.

Most analysts do not think that pessimistic scenario is likely.

"I don't think the last two weeks have any effect on earnings potential over the next twelve months," said Jeffery Harte, an analyst at Sandler O'Neill, who has "buy" ratings on both JPMorgan Chase and Citi.

"Unless this is the start of a global economic slowdown — I don't think it is — the wind is still at the backs of a lot of these big banks," he said.

Price-to-earnings ratio, the most popular stock-valuation shorthand, supports this rationale, and suggests that Bank of America, Citigroup and Wells Fargo are better buys now than they have been for at least the past year. Each stock's forward P/E ratio — based on analysts' earnings estimates for the next year — is lower than its ratio for the last year's earnings, which suggests that the investors have not yet caught on to analysts' optimism.

Even after the market started surging in the middle of the week, the four biggest banks still had not recovered to their share prices before the turmoil started. (The S&P, Dow Jones Industrial Average and KBW Bank Index were down only slightly in trading late Friday.)

Bank of America was the first megabank to generate rebound buzz because it is the least exposed to foreign markets and it is seen as more likely to benefit from a rate hike, whenever one comes. With $1 trillion in deposits, about half in non-interest-bearing consumer accounts, B of A should get a bigger boost than its peers from higher interest rates.

Bank of America "looks positioned to benefit from a handful of potential earnings drivers that could improve over the next year including higher rates, lower expenses and better trading revenues," wrote Sanford Bernstein analyst John McDonald, upgrading the bank's stock.

McDonald also noted that, at a time when China's problems have set off warning signs in other emerging markets, around 87% of B of A's revenue is generated domestically — a higher percentage than the bank's peers. JPMorgan gets around 74% and Citi just 47%, he wrote.

But even Citigroup, despite its international emphasis, is in better long-term shape than its share price suggests, argued KBW analyst Brian Kleinhanzl. The bank has become more tilted toward the U.S. over the past three years and its underwriting on foreign credits has improved, but the stock price does not reflect those evolutions, he wrote.

"We believe that [Citigroup]'s current share price reflects a meaningful slowdown in global growth and very elevated potential loss rates, but we do not believe this scenario will emerge," Kleinhanzl wrote.

In the shorter term, however, the third quarter could be a rocky one, partly because of the recent market movements, some forecasters warn. Large banks face headwinds particularly from trading in fixed income, currencies and commodities, which has become the bread and butter of investment banking in the past decade.

Brian Foran, a partner at Autonomous Research who covers large and regional banks, said FICC trading is "a big complicated beast," and September usually accounts for about half of third-quarter FICC revenue. Investors have been particularly focused on a breakdown in credit quality by looking at high-yield spreads compared with investment-grade corporate bonds and Treasuries.

"For the third quarter, there's still a growing nervousness, and spread indicators like high yield are pretty ugly," Foran said. "So the question is, are we setting up for another round of weak results?"

Commodity prices would suggest so. Some banks took a hit in the first half from falling energy prices and many assumed oil would rise to $50 to $60 a barrel. But oil futures and spot prices are now trading at 20% below those levels.

The implication, Foran said, is that "loans marked just two months ago might have more pain to come."

Sandler O'Neill's Harte, on the contrary, thinks that the third quarter is still up in the air but will likely be OK. September will be the pivotal month for investment-banking revenues from M&A, trading and equities underwriting because the summer months are always slow, Harte said.

For other key areas of bank earnings, like loan demand and margin, he does not expect any harsh surprises. That means the third quarter could be in line with the last few quarters — which should be just fine for banks whose share prices suggest far more dismal expectations.

"Moves of the market can become exaggerated in times like this," Harte said.