Play all audios:
Bank stock prices have increased significantly over the past couple of months.
In fact, the financials sector of the S&P 500 has been up more than any other sector since November 23, which was roughly the beginning of the current market rally.
Specifically, Financials have risen over 18% compared to an increase of slightly more than 12% for the entire S&P 500 . Similarly, the KBW Bank Index , which is a narrower index of the
Financials universe consisting of 24 major US banks, is up nearly 24% over that same time frame - double the increase of the S&P 500. Is this strength in the banking sector justified? What
is driving the strength and will it continue?
The primary driver of the recent strength, in our estimation, is valuation. Bank stocks had so under-performed the broader market since the Great Recession began that it may have just been
time for somewhat of a reversal. To put some numbers around the point, consider the following: the Financials sector of the S&P 500 fell over 55% from the beginning of 2008 through the end
of 2011. Over this same time frame the S&P 500 was down just over 14%. Bank stocks went from trading at a 2x or 3x (or more!) multiples to book values to discounts to book values, in most
cases. Over the course of this revaluation process, expectations for bank returns were scaled back dramatically - and perhaps too dramatically. Bank stocks that had once been expected to
generate returns well in excess of their cost of capital were suddenly not expected to ever earn their cost of capital again. And any company that is not able to earn its cost of capital
won't survive for very long.
More recently, however, bank stock investors have come to believe that they may have gotten too pessimistic with regard to future return expectations.
To be sure, there is little chance that the Goldman Sachs' of the world will ever go back to earning 25%+ returns-on-equity on a consistent basis. However, banks that are able to put up low
teens ROE's over a cycle most certainly deserve to trade at a premium to book value. We think investors are beginning to get comfortable with the fact that banks, by and large, should be
able to achieve these more modest targets in the future.
A second reason for the recent strength in bank stocks is improved fundamentals and earnings visibility. Without question, the entire sector has been held back by a slew of uncertainties
ranging from housing price declines to loan growth issues to regulatory changes. Ever so gradually, we are gaining more clarity with regard to these issues. Consider the following:
But while much has been clarified, uncertainties undoubtedly remain. For instance, the backlog of home foreclosures remains large, the ultimate level of mortgage "put-backs" is unknown, low
interests rates continue to drag down margins, the capital markets businesses may be in secular rather than cyclical decline, the Volcker Rule has yet to be defined, unemployment remains
high, etc, etc. These are legitimate concerns that will definitely affect the earnings power at banks. As long as uncertainties such as these remain, valuations will be penalized. However,
as issues get cleared up, one by one, investor reticence with regard to bank stocks should continue to decline. We once again quote Joe Rosenberg, Chief Investment Strategist at Loew's: "You
can have cheap equity prices or good news, but you can't have both at the same time." In other words, it will be too late if we wait for all the risks and uncertainties to clear up. Bank
stock valuations will have already risen to reflect the improved outlook.
So, in a nutshell, the rally in bank stocks we are seeing is due to a combination of super-cheap valuations and the alleviation of some of the uncertainties that had been weighing down the
sector. As long as the visibility surrounding future bank earnings power continues to improve, we would expect valuations to improve and bank stocks to continue to perform well relative to
the overall market. After the recent increase in prices, earnings disappointments or other bits of adverse news will likely cause setbacks. Those strike us as near term issues which may add
to volatility but should not derail clear, albeit plodding, long-term progress.
Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is
quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.
Sign up for free newsletters and get more CNBC delivered to your inbox
Get this delivered to your inbox, and more info about our products and services.
© 2025 CNBC LLC. All Rights Reserved. A Division of NBCUniversal