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As an interest rate cut looms, traders say these are the bank stocks to own

Key Points
  • Comerica was downgraded to a “sell” rating by Goldman Sachs on Tuesday.
  • Goldman believes regional bank net interest margins may come under pressure in the coming quarters if the Federal Reserve cuts interest rates.
  • Hightower Treasury Partners’ Richard Saperstein prefers large cap banks like J.P. Morgan, Bank of America, and Citigroup.

Comerica has declined more than 30 percent from its March 2018 all-time high, and Goldman Sachs sees that downtrend continuing.

On Tuesday the firm downgraded the stock to a "sell" rating, citing the negative impact that a rate cut by the Federal Reserve would have on the regional bank's margins.

The stock slid more than 3% on Tuesday following the downgrade, although shares did rebound slightly on Wednesday.

Stock sell-offs can present a buying opportunity, but some traders say there are far better ways to play the financial sector.

Comerica cut to sell at Goldman Sachs

"I don't see the lift for Comerica. They had a bad quarter in the prior quarter and got punished for it," Virtus Investment Partners' Joe Terranova said on Tuesday's "Halftime Report." "I can't see any visibility going forward that's going to act as a catalyst."

Terranova instead favors Signature Bank since he believes that exposure to real estate is one way investors can differentiate between similar regional banks.

"You want to be in banks that don't have the exposure to where real estate is in a decline… Signature Bank provides you that opportunity." Signature Bank has a market cap of $6.8 billion and yields 1.8 percent.

In his bearish note to clients Tuesday, Goldman Sachs analyst Ryan Nash reiterated his 12-month price target of $70 per share for Comerica, with his downside case built on an expected decrease in net interest margin that will follow any Fed rate cuts.

A bank's net interest margin is the difference between the revenue earned from collecting loan payments, and the interest it pays to depositors. When the Fed is raising interest rates, banks can charge more for loans and increase their net interest margin. On the flip side, when rates are cut -- which the central bank hinted might be coming -- a bank's margins decrease.

"With the forward curve pricing in 4 rate cuts through year-end 2020, bank margins are likely to be under pressure in the coming quarters… Overall we see 11% (gross) EPS risk to banks from lower rates," Nash wrote.

Even if the Fed doesn't cut rates or leaves rates unchanged, Nash believes margins are "likely to still be under pressure" due to the yield curve flattening this year. This is when the spread between shorter and long-term Treasury rates narrows, and typically indicates market sentiment turning cautious. The yield on the 10-year Treasury note fell to its lowest level since November 2016 early on Wednesday.

Like Nash, Short Hills Capital Partners' Steve Weiss believes that the current interest rate environment will continue to be a headwind for Comerica and the banking sector more broadly. "I just think it's very tough given where rates are and where the [yield] curve is for them to make money… I just don't see the alpha really in the banks," he said.

These concerns notwithstanding, the narrative surrounding bank stocks hasn't all been negative. Financials were the top performing sector in the S&P 500 during the second quarter, and the big U.S. banks passed the second round of the Fed's annual "stress test" at the end of June.

This annual assessment evaluates banks' ability to withstand heightened stress on the U.S. financial system, including a recession. Following the test, the banks were given the green light to increase their dividends and share repurchase plans, which is one of the reasons Hightower Treasury Partners' Richard Saperstein is bullish on the large-cap banks.

"The return of capital to shareholders is just incredible right now," Saperstein said on Tuesday's "Halftime Report." "They're averaging 10, 11, 12 percent return of capital through buybacks and dividends, their cash flow is very strong and return on equity is elevated."

Specifically, Saperstein likes J.P. Morgan, Bank of America, and Citigroup. All three banks raised their dividends by 10 percent or more, and were authorized to repurchase a combined $81 billion worth of shares after the results of the Fed's stress test.