I’m investing in Bank Stocks more quickly this year than I did in previous years. I made the decision to reduce my exposure to IT stocks and increase my holdings in value industries instead, such as banking and oil, after learning that central banks would be rising interest rates this year. The plays in banking are down, but I believe they have a decent possibility of recovering in 2023. My investments in oil returned rather rapidly. My two key arguments for thinking are as follows.
Reason #1: Bank stocks are very cheap
Currently, bank stocks are quite affordable. They typically trade at less than 10 times earnings both in Canada and the US. The majority of the time, their incomes are declining, but not drastically. In many situations, banks without investment banking divisions are reporting positive earnings growth.
For instance, consider Toronto-Dominion Bank (TSX:TD). Along with Bank of America, this is one of the bank stocks I purchased this year. It trades at the following prices today:
- Nine times adjusted earnings (“adjusted” means “not calculated with the normal accounting rules”)
- 9.5 times reported earnings (“reported” means “by the normal accounting rules”)
- 1.4 times book value (“book value” means “assets minus liabilities”)
All of these ratios are quite low, indicating that TD is undervalued. Additionally, TD’s earnings are really increasing. In its most recent quarter, TD’s sales fell just 1.6% but its adjusted profitability rose. Although there are certain difficulties, TD is not 20% less lucrative than it was at the beginning of the year, as the markets tend to believe.
Reason #2: Interest rates are rising
I prefer bank equities this year for a second reason: rising interest rates. Both the Federal Reserve and the Bank of Canada are increasing interest rates, and while they might be profitable for banks, this is not a given.
In essence, banks get more interest revenue when rates rise if the increase is parallel across the yield curve. A chart of bond rates organised by maturity is known as a “yield curve” (term to maturity is the period of time before principal is repaid). Banks benefit when bond yields rise because it widens the disparity between their funding costs and lending rates. This is true of both short-term and long-term bond yields.
However, banks lose out if yields rise on short-term bonds but not long-term ones since it increases the cost of running their businesses. The yield curve is inverted so far this year, but as we emerge from the recession, that will alter. Banks will then be able to benefit from higher interest rates.
One big risk with this strategy
As I’ve demonstrated, there are now a lot of macroeconomic variables pointing to respectable returns on bank stocks in 2019. However, there is one risk you should be aware of: the potential for a severe and protracted recession. Many people predict that we will see a very mild and brief recession this year. That wouldn’t pose a serious threat to banks, but a deep and protracted recession would. Therefore, be aware of the potential for a catastrophic recession. It would contradict my optimistic view of banks.