Banks have consistently underperformed the broader market over the past couple of years. And, this trend has continued in 2020. YTD, the S&P 500 is up 15.1%, while the Financials Select SPDR ETF (XLF) is down 3%.

A combination of cyclical and secular factors account for this weakness. Following the financial crisis in 2008, the US government placed more strict regulations on banks which limited their ability to take risks and engage in the type of financial engineering which made them so profitable during the last cycle. Another factor was the constant, downtrend in long-term interest rates.

For example, in July 2009, the yield on the 30-year Treasury was 4.50%. Currently, it’s at 1.7%. This means the yield curve is flatter, thus lending money is less profitable. Commensurate with this factor is that demand for loans has also been weak due to the economy’s underwhelming growth over the past decade.

Finally, there’s a new crop of fintech companies that have been gaining market share and disrupting traditional financial practices. Just like technology is doing in many other industries, it’s resulting in more transparency and decreased transaction costs, leading to pressure on margins.

A Turn in the Trend

However, markets are cyclical. Periods of underperformance are followed by periods of outperformance. I believe that conditions are improving for bank stocks, and they will exceed expectations in 2021.

The first reason to be bullish on the sector is that economic growth should be strong in 2021 due to heavy doses of monetary and fiscal stimulus in addition to the economy reopening. This should lift longer-term interest rates. At the same time, the Fed has indicated that short-term rates will remain at zero all year. This will result in a steeper yield curve which should lead to increased profits for banks.

Another reason is that banks passed the Fed’s recent stress test. As a result, the Fed loosened limits on share buybacks and dividend increases which should make these stocks more attractive to investors. These stress tests are designed to decrease the chances of another financial crisis by ensuring that banks have enough capital, so they will be able to keep lending under adverse conditions.

In addition to the Fed’s stress test, we had a real-life stress test with the coronavirus and economic shutdowns. While it did have a short-term, negative impact on earnings, most of the earnings decline was due to banks increasing reserves rather than defaults.

If the economy does perform better than expected, then it’s likely that defaults will be lower than anticipated. I believe this is quite likely. The combination of a buoyant housing market, record-high stock prices, and robust levels of household savings are supportive of this outcome.

Four Banks to Buy

Further, the tough conditions for the financial industry also led to consolidation in the sector with bigger banks buying smaller banks. This will result in decreased competition and higher margins. The banking system is emerging from the coronavirus crisis in remarkably good shape compared to the last crisis.

Monetary and economic conditions are quite supportive of earnings growth. Investors should consider buying high-quality bank stocks that will do well in 2021 such as JPMorgan (JPM), Bank of America (BAC), PNC Financial (PNC), and Goldman Sachs (GS).

Bank of America (BAC)

BAC is one of the most interest-rate-sensitive banks due to its large consumer business and commercial bank. If the 10-year Treasury yield increases by 100 basis points, it would translate into an incremental $10 billion in pre-tax earnings. This makes BAC an attractive option for investors who believe that 2021 will feature a strong economy.

The stock is attractive from other perspectives as it has a price to earnings ratio of 15 which is significantly cheaper than the S&P 500’s price to earnings ratio of 37. It also has a 2.4% dividend yield.

On a technical basis, BAC is breaking out to new, post-pandemic highs. It’s been one of the winners of the past couple of months as value stocks have been outperforming growth in anticipation of the economy reopening. Thus, BAC is a rare stock that is attractive to both – short-term, technically-oriented traders and long-term, value investors.

The POWR Ratings are a Buy on Bank of America. It has an “A” for Trade Grade with a “B” for Buy & Hold Grade, Peer Grade, and Industry Rank. Among Money Center banks, it’s ranked #4 out of 10.

Goldman Sachs (GS)

GS is less interest-rate sensitive than BAC since its business is more connected to Wall Street rather than Main Street. While Main Street is in the early stages of a recovery, Wall Street is flush due to the Fed’s rate cuts and liquidity programs. Stock prices are at an all-time high, the IPO market is booming, and M&A activity is strong as well.

This favorable environment is reflected in GS’s last earnings report. The company earned $9.68 per share which handily topped analysts’ expectations of $5.57 per share. Compared to 2019’s Q3, trading revenue was higher by 29%, and asset management revenue was 71% higher.

It’s also been a standout performer relative to other financial stocks. YTD, Goldman is up 15%. Further, it’s set to open above its all-time highs today on a dividend-adjusted basis, while XLF is 5% below its all-time high set in October 2018.

GS is also attractive from a fundamental basis. In sum, it’s cheaper than the S&P 500, while paying a higher dividend yield and having a faster growth rate with bigger profit margins.

According to the POWR Ratings, GS is a Strong Buy. It has an “A” across all categories including Trade Grade, Buy & Hold Grade, Peer Grade, and Industry Rank. Among Investment Brokerage stocks, it’s ranked #3 out of 27.

JPMorgan (JPM)

JPMorgan is considered one of the most high-quality banks with its “fortress” balance sheet. The company has a blend of exposure to Wall Street and Main Street. It’s also remained profitable during the crisis due to strong performance from its trading division. JPM also instituted a $30 billion share buyback following the Fed’s loosening of restrictions and is expected to hike its dividend sometime in 2021 as well.

However, as the economy recovers, JPM’s consumer and small business banking will go from a headwind to a tailwind. There are already signs of this in its recent earnings report in which the bank stated that loan demand was recovering and loan deferment requests fell by half.

Contrary to expectations, JPM actually lowered its loan loss reserves due to lower defaults than expected. In Q1 and Q2 of this year, the bank had set aside $10.5 billion. If the economy continues to improve, this will provide a steady boost to earnings in the coming quarters.

JPM also has an attractive fundamental profile with a forward price to earnings ratio of 13.5 and 34% profit margins. In its most recent quarter, it posted earnings per share of $2.92 which was significantly above analysts’ expectations of $2.23. Revenue came in at $29.9 billion which was $1.5 billion above consensus.

JPM is rated a Buy by the POWR Ratings. It has an “A” for Trade Grade and a “B” for Buy & Hold Grade, Peer Grade, and Industry Rank. It’s ranked #3 out of 10 Money Center Banks.

PNC Financial Services Group (PNC)

PNC has more exposure to consumer and small business banking, thus it should be the biggest beneficiary of a steeper yield curve and improving economy. Due to the pandemic, its revenues declined by 23%.

The last decade has been tough for regional banks due to the flattening yield curve. Additionally, many banks in the Southwest endured heavy losses due to weakness in the energy sector. PNC has used this as an opportunity to scoop up competitors at a discount. As a result, it’s become the fifth-largest bank in the US. In November, it acquired BBVA USA for $11.6 billion which added 637 branches and $110 billion in assets. It also gave it a foothold in the fast-growing, Texas market.

Currently, PNC has a dividend yield of 3.1% and profit margins of 59% with a forward price to earnings ratio of 16. While it’s considered a regional bank, due to its acquisitions, it has a coast-to-coast presence. I believe that PNC has the most upside compared to GS, BAC, and JPM in 2021.

PNC’s bullish outlook is confirmed by the POWR Ratings as it’s rated a Strong Buy. It has an “A” for Trade Grade, Buy & Hold Grade, and Peer Grade with a “B” for Industry Rank. Among Money Center Banks, it’s ranked #1 out of 10.

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JPM shares were trading at $125.73 per share on Tuesday morning, up $0.39 (+0.31%). Year-to-date, JPM has declined -6.53%, versus a 17.95% rise in the benchmark S&P 500 index during the same period.

About the Author: Jaimini Desai

Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of the POWR Growth and POWR Stocks Under $10 newsletters. Learn more about Jaimini’s background, along with links to his most recent articles. More...

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