In this article, we'll evaluate bank stocks and discuss whether an investment in the sector is still worthwhile now that inflation (and rate hikes) have (apparently) peaked.
Understanding market dynamics
Inflation has dominated the economic discourse for the better part of two years now. But after the Consumer Price Index reached 40-year highs in 2022, disinflation set in and 2023 ended with the popularly-quoted inflation rate hovering around 3%. However, interest rates remain elevated, meaning banks pay more to depositors but can also charge higher rates for their loans.
Are high rates good or bad for banks? It depends on the environment. The Federal Reserve (the Fed) uses high rates to temper loan demand. Still, if economic activity is vigorous and companies continue borrowing, bank stocks benefit because customers accept higher loan rates.
High rates also benefit those with cash in savings accounts since banks can afford to pay more interest on deposits. High rates can be a boost for bank stocks, but not if they curb demand for capital.
Evaluating the banking sector
How healthy is the banking sector heading into 2024? Despite the stress of inflation and regional crises in 2022 and 2023, the sector shows impressive strength. Large-cap bank indices are near all-time highs, and Q3 reports 2023 showed major players beating estimates thanks to increased interest income.
But 2024 could be volatile for banks as the Fed may cut interest rates, and an unpredictable presidential election awaits in November.
When Silicon Valley Bank and First Republic Bank collapsed, the regional banking sector suffered a crisis, but larger firms like Goldman Sachs and Wells Fargo were largely unaffected.
Large bank profits were strong, and these companies saw their stock prices reach (or near) all-time highs as Q4 ended. But the stocks of regional banks are still languishing. The SDPR Regional Banking ETF NYSE: KRE plummeted in March and remains well below its December 2021 all-time high today. Regional bank earnings were a mixed bag in Q3 in 2023; this sector area could also see more volatility in 2024.
Risks of bank stocks
The banking sector is one of the oldest, but that doesn't mean it's immune to uncertainties. New bank stocks tend to face the same risk as old ones, so keep an eye on the following factors when investing in the financial industry.
Interest rate risk
The Federal Deposit Insurance Corporation (FDIC) defines interest rate risk as "the exposure of a bank's current or future earnings and capital to adverse changes in market rates."
If interest rates are at 5%, banks can reasonably lend capital to borrowers at around that same rate. If rates lower to 4%, those 5% loans suddenly become less manageable, and banks will need to lower rates on their loans to sustain their business.
Additionally, interest rate risk can affect the bonds issued by institutions. For example, if a bank issues a bond with a 5% coupon and rates rise to 6%, the bond with the 5% coupon will lose value since banks will issue newer bonds with the 6% rate. Rate changes impact all stock sectors, but rate changes more heavily influence banks.
Bad loans
The more official sounding term for this is “counterparty risk,” but the reality is that banks can suffer if they hand out loans to high-risk borrowers. Banks price their loans based on the creditworthiness of each borrower, whether it's a person, business or institution.
A borrower with poor credit will pay a higher interest rate than one with good credit since poor credit comes with a higher risk of default. For example, First Republic Bank had too many risky loans on its balance sheet when it collapsed in 2023.
Recession sensitivity
Banks are a relatively safe sector since they're typically older, established firms with low volatility and healthy balance sheets. But that doesn't mean they are insulated from the effects of economic downturns. When recessions hit, companies slow down on their expansions and new ventures. When companies get cost-conscious, they tend to borrow less money, which hurts banking profits.
Regulatory risk
Also known as compliance risk, regulatory risk refers to the concept that changes in laws or regulations will adversely affect banks. For example, if capital requirements are changed, banks may be forced to lend out a lower percentage of their profits.
New laws can also increase costs, making it more expensive for banks to comply with the legislation. Regulatory risk is always present in the banking sector since the federal government watches it more skeptically than other sectors.
Bank runs
A bank run can be devastating — just ask Silicon Valley Bank, which went bust in early 2023 following a massive run on the bank's deposits.
What causes a bank run? When depositors lose faith in the institution, they may attempt to retrieve their cash en masse.
But a bank doesn't keep all deposits; it lends that money to investors or individuals to generate income. The Fed sets reserve requirements indicating what percentage of deposits a bank can lend out.
So, if all depositors try to pull their money out simultaneously, the resulting "run" will deplete the bank's cash reserves and may prevent depositors from receiving their cash.
Benefits of bank stocks
Bank stocks have many benefits that seem counterintuitive to traditional investing tents, especially when interest rates are rising. Here are a few of the biggest pros of investing in bank shares.
High dividends
The financial sector tends to be full of dividend payers, and few companies have more consistent dividends than banks. Dividends are payments made to shareholders from a company's pool of excess profits. Instead of reinvesting these profits into the firm (something familiar in growth stocks like tech), banks tend to reward their shareholders by distributing these profits as dividends.
When investing for dividends, consider how long a company has increased its payments and whether the dividend payout rate is sustainable. It's also essential to view the sector and compare individual bank dividends to their peers (instead of the market as a whole).
Low volatility
Different types of investors have differing views on volatility. Short-term investors crave volatility because it allows them to profit quickly, provided they're on the correct side of the trade. On the other hand, high volatility brings risk because losses can mount rapidly if the trade doesn't pan out.
The banking sector tends to have low volatility, which may appeal more to long-term than growth investors. Still, buy-and-hold investors looking for steady gains (and dividend income) can find solace in the relative predictability of banks.
Beneficiaries of high interest rates
Most companies hate high interest rates because it increases their capital acquisition costs. However, since banks lend money, high interest rates often increase profit margins since banks can apply higher rates on their loans.
Because banks aren't too friendly with giving those same rates to their depositors, interest rate hikes often result in bank profits. (Check the APY of your savings account and compare it to mortgage rates offered by the same institution — you'll see how these profits accumulate.)
Commercial and investment banking
The banking sector is split into two groups, offering investors two paths to profit:
- Commercial banks: Commercial banks provide services for retail customers, such as checking, savings, wealth management, mortgages and other kinds of loans.
- Investment banks: Investment banks invest client capital to earn a return on the assets under management.
Many institutions offer both types of banking services under the same umbrella. For example, JPMorgan Chase and Co. NYSE: JPM is famous for its investment banking wing, but it also offers commercial banking services to retail customers with physical branches nationwide.
Expert opinions and market outlook
The outlook for the banking sector in 2024 varies depending on which section you look at. For large banks, the outlook is sunnier. XLF, the large bank ETF, currently has a "moderate buy" from analysts, with an average price target showing a 4.6% upside.
Index constituents like large commercial banks, insurance companies and broker-dealers boast mostly "buy" or "hold" ratings.
The picture is murkier if you look at SPDR S&P Regional Banking ETF NYSEARCA: KRE, the regional bank ETF. KRE is currently listed as a "hold," and analyst price targets show an average projection 2% lower than the current market price. Many of the index’s constituents, like Bank of the Ozarks NASDAQ: OZK and Bank of Hawaii Co. NYSE: BOH, have double-digit downsides and "reduce" ratings on their stocks.
Are bank stocks a good buy right now?
High interest rates have brought a reprieve to the sector, but with many major bank stocks down, is this sector a buy?
Unfortunately, the answer is more muddled than investors would prefer. Interest rates have risen dramatically, but the pace of rate hikes has slowed, and banks may have already captured much of the upside in this environmental shift.
In 2023, tech stocks retook the headlines, especially as markets approached all-time highs toward the year's close. But 2023 was also another solid year for banks. Big companies like JP Morgan and Wells Fargo and Co NYSE: WFC hit new all-time highs as 2023 drew to a close, and banking ETFs like Financial Select SPDR Fund NYSE: XLF aren't far off their highest-ever marks either.
For example, the chart above shows JPMorgan Chase has outperformed the S&P 500 over the last 12 months. However, the sector's response to slowing rate hikes could be hard to predict; inflation is slowing, so rate increases may not provide the same boost for banks as the previous year.
Are bank stocks best for your portfolio?
With high rates and volatility slowing, it's difficult to pinpoint why bank stocks are down below their all-time highs. While the banking sector has bested the S&P 500 over the last year, bank stocks still haven't reached their zenith, and the industry outlook in 2024 is murky.
Will rate hikes continue to support the sector? Or will a slowdown in rate increases minimize the profits banks have been enjoying over the last 12 months? This market environment is unique, and investors must remain nimble to navigate these opposing economic forces.
FAQs
Are bank stocks a good buy right now? Financial firms tend to do well when interest rates rise, but the rate of future increases is currently in question. Investing is never a cut-and-dried endeavor. Here are a few commonly asked questions about investing in bank stocks in 2024.
What are the best bank stocks to buy now?
The best bank stocks are usually large institutions with stable dividend payments that can withstand economic slowdowns or changes in interest rates. Of course, the best bank stock for each investor will differ depending on goals and personal risk tolerance.
Is investing in bank shares a good idea?
Bank shares can be a good investment if you seek income from dividends and low-beta stocks. However, before risking any capital, ensure a bank stock purchase fits your investment plan and long-term goals.
What stocks will boom this year?
Identifying which stocks will boom in a particular year is often an exercise in futility. Economic and geopolitical events are challenging to predict, and stock prices don't always behave as expected. For example, bank stocks rose along with interest rates in 2022. But now that rates are cooling (with cuts potentially coming), tech stocks have rebounded and market indices have hit new highs.
Despite elevated rates, tech stocks started 2024 hot, which has baffled some investors.
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