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A big part of the market is headed for the rocks

Pedestrians walk in front of Goldman Sachs Group's headquarters in New York.
Victor J. Blue | Bloomberg | Getty Images
Pedestrians walk in front of Goldman Sachs Group's headquarters in New York.

Bank stocks have had a tough start to 2015 and could face even more difficult sledding should current conditions hold up.

Analysts have soured on the sector amid anticipation that interest rates are going to stay lower than many in the market had expected, and as the regulatory vise tightens on those banks considered a danger to the financial ecosystem and the economy as a whole.

Financial services firm Keefe, Bruyette & Woods warned clients in a recent report that unless government bond yields rally in a meaningful way, it will be hard for many banks to shake off the current doldrums.

"While a number of factors have driven the underperformance, the primary factor has been the drop in government bond yields and market expectations for continued low interest rates," KBW said in a note authored by analysts Frederick Cannon and Matthew Dinneen. "This has been augmented by reduced forward earnings estimates for interest rate sensitive financial stocks as analysts have not found offsets to lower interest rates, and lower margins, for many financial firms."

Investors have been looking for rising rates and a steepening yield curve—or the difference in rates between varying maturities—as a way for banks to accelerate profits.

However, with the Federal Reserve set to tighten monetary policy and raise rates incrementally, and as U.S. bond yields are high relative to many of their global competitors, the formula seems tilted against bank outperformance.

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Moreover, the outlook for corporate profits in general has dimmed, with S&P 500 companies substantially lowering forecasts for 2015 earnings growth.

Banks are the second-largest sector in the broad stock index, comprising 16.2 percent and trailing only information technology, which accounts for 19.5 percent of the total market cap.

"While earnings estimates came down for financials following fourth-quarter results, they came down significantly less for financial stocks than for the overall S&P; thus market expectations are for further estimate reductions in the sector," KBW said. "We believe this is likely unless bond yields move back to a sustainable level above 2 percent."

The firm is recommending clients look for high-yielding financials within select sectors such as real estate investment trusts as well as those banks whose dividends seem likely to grow. REITs as a group are up 7 percent in 2015.

KBW has an exchange-traded fund dedicated to high-yielding financials, the $273.8 million PowerShares KBW High Dividend Yield Financial Portfolio, that has as its biggest holdings companies including Medley Capital, Triangle Capital and Invesco Mortgage Capital. The fund is down 1.37 percent year to date though it has gained 1.58 percent so far in February.

KBW is not alone in its caution about banks, whose sheer numbers have been declining precipitously over the past 30 years as they've weathered two major crises.

The vanishing banking industry

Year
Total Banks
1984 14,389
1994 10,521
2004 7,595
2014 5,636
St. Louis Federal Reserve (data from third quarter of each year)

Dick Bove, the high-profile vice president of equity research at Rafferty Capital Markets, has reversed a strongly bullish call he made when joining the firm two years ago. In late January 2013, Bove predicted that banks were just taking off on a 14-year bull run propelled by stellar earnings and rock-solid balance sheets.

Now he sees an industry that has become the victim of a "de facto nationalization" by the government and its Fed regulatory arm, destined for weak performance unless conditions change. Bove believes the government is so intent on keeping banks out of taking significant risks that it is willing to hamstring the industry and relegate it to little more than buying bonds to underwrite government debt.

"The problem is trying to make money," he said in a phone interview. "If the government is convinced that it's going to control the balance sheets of the industry and is going to control it in a fashion that doesn't allow it to make money, it's going to have a negative effect on the stocks."

At least on paper, banks have been making money in record numbers, and share prices have been rising.

However, the sector has underperformed the stock market for the past five years. During the period, the S&P 500 gained more than 79 percent while the KBW Bank Index has risen 59 percent.

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In 2015, the S&P bank stocks have fallen about 5.4 percent, while the financial sector as a whole is off 2.44 percent. Consumer finance is the worst subsector in the group, falling 7.6 percent, according to FactSet.

Bank earnings were a bit of a disappointment for the fourth quarter, with just 45 percent beating estimates, compared with about 72 percent for the S&P 500.

Still, Bove makes room for outperformance within the sector, but said four companies look particularly strong: SunTrust, Bank of America, Morgan Stanley and BNY Mellon. (Disclosure: Neither Bove nor Rafferty has an ownership stake in any of the banks.)

More broadly, he said the industry has been able to show balance sheet profits through accounting gimmicks and the use of outsized reserves banks were required to accumulate after the financial crisis.

"Get rid of all the impact of stuck buybacks. Did companies show increases in earnings or not in the seven-year period?" since the crisis, he said. "The answer is clear as clear can be: They did not. Seven years, and no increase in earnings."

For their part, bank CEOs have been trying to dispel their negative image.

Goldman Sachs CEO Lloyd Blankfein, at a conference this week, touted the vilified Wall Street giant as a model of stability. stressing that his firm's earnings have been less volatile than its peers.

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Investment banking specifically has limped out of the gate in 2015, generating $3.3 billion so far across the board, a number that is down 11 percent from the same period in 2014 and 10 percent from 2013, according to Dealogic.

Banks, then, are seeking other business avenues to generate returns, with Bove expecting a focus on wealth and asset management and payment services, while contending that investment banking also will be strong going forward.

"There's been more regulation, new capital standards—every financial institution has had to adjust their business model," Greg Fleming, president of Morgan Stanley Investment Management, told CNBC. "For us, we're spending most of our efforts on execution and trying to drive forward the business mix that we have. We think we have a good set of businesses coming out of the crisis."

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