Is it time to buy bank stocks?

The financials sector is the worst-performing of the ten S&P 500 industry sectors this year. As a group, these stocks are down over 6 percent year-to-date. The bulk of the companies within the financials sector are banks, and the largest of these banks are included in the KBW Bank Index. Despite a sizable 12 percent bounce since the mid-February lows, the BKX is still down nearly 13 percent so far this year — well below the 1 percent increase in the S&P 500. What's causing the banks to underperform by such a wide margin so far this year?

The stocks had made a dramatic recovery since the financial crisis, perhaps appreciating beyond levels supported by the fundamentals:

  • There were high expectations that the Fed would follow through with its prior estimate of four additional rate hikes in 2016, which would dramatically improve the outlook for bank interest margins. This no longer appears likely;
  • Lower loan loss provisions had been a source of earnings growth for many years. It now appears that credit quality is deteriorating again, led by loans to the energy industry;
  • Capital-markets related income is suffering from a general increase in risk aversion and new regulatory constraints;
  • Many of the banks have already cut expenses dramatically, essentially reaping all the low hanging fruit;
  • The new regulatory environment is still far from resolved. The latest issue is the new Fiduciary Rule, which will likely affect the money center banks the most;
  • Consolidation is less likely given increased capital requirements and low stock valuations;
  • Mortgage-related income is likely to suffer going forward absent another sharp drop in mortgage rates (and another "refi boom");
  • The European banking system has yet to recapitalize, and we are likely to encounter more flare-ups in the future that draw attention to counter-party risk;
  • Bank returns on equity are likely to suffer a permanent shift lower to reflect the new higher capital requirements and other regulatory restrictions on operations.

For all these reasons, we too have been wary of increasing our exposure to bank stocks. Our major concern was that we did not believe that the economy was strong enough to support meaningfully higher interest rates. We were also concerned by the apparent trough in credit losses. Our worry was that credit quality would begin to deteriorate before the banks got major relief from higher interest rates, creating pressures on earnings. To a large extent, our expectations have been realized.

But the 21 percent drop in the BKX from last year's peak is now starting to reflect the banks' earnings challenges. Current valuations are much less demanding, and investors should assign some value to the banks' vastly improved balance sheets and dividend payouts (which should continue to increase over time).

According to our numbers, the average large-cap regional bank now trades at just 1.0x book value, 1.3x tangible book value (excludes goodwill and other intangible assets), and carries a 2.6 percent dividend yield. Valuations at the money center banks are even more attractive at 0.7x book value, 0.9x tangible book value, and a 1.8 percent dividend yield. These trading levels are more commonly associated with an economic recession.

One final argument for increasing bank exposure might be that bank stocks could provide some portfolio insurance against higher interest rates. While we think the economy is still not strong enough to support sharply higher interest rates, we do think the Fed has now met or exceeded its policy objections.

Yes, Chair Janet Yellen has articulated some concerns about the labor market, including low labor participation, weak wage growth, and a surge in involuntary part-time jobs versus full-time work. But she and others at the Fed are generally quite gratified by the halving of the unemployment rate from 10 percent in 2009 to 5 percent, which is below the Fed's stated target.

Regarding the inflation side of the Fed's dual mandate, most metrics show that inflation now exceeds the Fed's target of 2 percent as well. In particular, inflation is running hot if we exclude the volatile categories of food & energy (as the Fed tends to do) or if we look solely at non-discretionary and service categories.

Therefore, from where I sit, it seems like that the Fed will resume with rate hikes now that financial conditions are less "tight", which was the excuse for reducing the estimated rate hikes from four to two at last month's meeting.

It is fairly indisputable that banks need higher interest rates in order to grow their most important source of earnings — net interest income. It has also been well established that the stock market pulls back any time the Fed adopts a more hawkish stance (ie, when it telegraphs interest rate hikes).

So, if bank earnings growth (and therefore bank stock prices) increase with higher interest rates, then it seems to reason that owning bank stocks can serve as a hedge against Fed tightening. Given current valuations, this might be insurance worth buying.

Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor. Follow him on Twitter @Michael_K_Farr.

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