What’s Behind the Newfound Love Affair With Bank Stocks?

The Dow Jones Industrial Average is setting all-time highs. So is the S&P 500. The Nasdaq Composite isn’t quite there yet. But it’s getting closer to the peak it made during the 1999-2000 tech stock blowoff.

But your average bank stock? It lagged badly during the market recovery of the past few years. The broadly diversified Financial Select Sector SPDR Fund (XLF) is still going for around $22, far below the 2007 peak of $38. That’s a sign of just how serious the housing and credit market collapses were.

Yet that trend is starting to change. While the broad market has struggled out of the gate so far in 2014, bank stocks have been on fire. Several super-regional banks, like BB&T Corp. (BBT), KeyCorp (KEY) and Comerica (CMA) are setting new multi-year highs, while other larger bank stocks like Citigroup (C) are finally crawling out of the shell they retreated into for several months last year.

So what’s behind this newfound love affair with bank stocks? And should you join in?

So far this year, bank stocks have been on fire.

I see a few things going on.

First, the economic recovery is good news for loan demand and credit quality. The better off consumers and businesses feel, the more they’ll borrow and spend. And the more income they’re bringing in, the lower the default rate will fall.

Second, the impact of tighter regulation and mammoth settlements for everything from the mortgage meltdown to the Madoff scam has largely been priced in. The fear of massive new lawsuits and tighter regulatory scrutiny held back many bank stocks in 2012 and part of 2013. But investors have largely come to grips with those risks and now believe the worst news is behind the major banks.

Third, the Federal Reserve is starting to exit stage right when it comes to suppressing interest rates. That is by far the biggest factor that has investors jazzed about banking prospects. That’s because the Fed-induced squeeze on net interest margins (NIM) is poised to let up.

NIM is a core profitability measure for banks of all types and sizes. It refers to the difference between a bank’s cost of money and what it earns on that money.

Consider this simple example: Say a bank pays a depositor 3 percent in interest for the use of his funds. Then that bank turns around and lends that depositor’s money out at 6 percent to a corporate borrower. The difference between what the bank paid to get the money and what it could earn on that money is 3 percent. That’s the NIM of the transaction.

Now, obviously, things get more complex than that. Banks have thousands of borrowers, depositors, outstanding debt securities and more. But you get the picture.

So how does Fed policy factor in? Well, policymakers cut short-term rates to near zero percent a few years ago. That initially drove down the cost of funds for all banks. But since banks can’t cut deposit rates below zero, the cost of raising money from depositors bottomed out some time ago.

Then when the Fed agreed to buy trillions of dollars of long-term bonds as part of its QE programs, it helped depress the yields available on long-term securities. That also pushed long-term loan rates down.

Result? The front-end cost of raising money for banks stopped falling, while the back-end yields those banks could earn from investing and lending money declined. That killed profit margins across the banking sector.

Now the Fed is actively tapering QE just as I forecast it would. It started off with $10 billion this month and will most likely lop at least another $10 billion off the program at each of its next several meetings. The Fed has also completely lost its battle to anchor long-term yields, which are rising across the board. That is alleviating the NIM squeeze for banks … and if rates continue to climb this year and next as I believe, even more relief is coming down the pipeline.

The trick is knowing which banks can benefit from these emerging trends, and which financials will get hurt by them. Not all banks are positioned for the kind of interest rate shifts we’re seeing. Some are highly exposed to businesses like mortgage lending, which will get hurt by higher long-term rates.

Until next time,

Mike