Why Big Bank Stocks Are No Longer Cheap

Bank stocks have had a banner year, even if big names in artificial intelligence like Nvidia NVDA have dominated headlines. The Morningstar US Banks Index is up more than 40% over the past 12 months and 9.7% since the beginning of 2024. The US market is up 35% and 9.4% over those periods.

But analysts aren’t confident that these outsize gains can continue, especially for large banks, which for the most part are no longer trading in undervalued territory, as they were during last spring’s crisis.

Climbing valuations mean banks are “not a sectorwide play,” says Morningstar equity analyst Suryansh Sharma.

Still, Morningstar analysts think there are some opportunities, including US Bancorp USB, which is up 32% over the past 12 months but flat since January, and Toronto-Dominion Bank TD, which has climbed 6% and declined 7% over the same periods. They recommend looking to pockets of value within the group.

Here’s what investors need to know.

Why Have Bank Stocks Rallied?

A year ago, panic over the failures of Silicon Valley Bank and First Republic Bank sent financial stocks plummeting as depositors rushed to withdraw their cash. As shares took a nosedive, market watchers wondered whether the US financial system was at risk.

Strategists say investors don’t need to worry too much about a replay of that scenario anytime soon. Banks generally have plenty of cash to weather storms, and the Federal Reserve has proved it will step in quickly to prevent a total meltdown.

“The system is very sound. It’s operating with more capital than at any given point in history,” says John Baldi, portfolio manager at ClearBridge Investments. “It feels pretty good from a very high-level lens, especially for the larger institutions.”

There are also macroeconomic factors supporting banks. Inflation has fallen and interest rates have stabilized after the turmoil and uncertainty last spring, says Sharma. Banks could have to write off losses on loans that have failed to materialize. Sharma also adds that pressures have eased on liabilities in bank balance sheets. For example, depositors are no longer rapidly withdrawing money.

What to Know About Investing In Bank Stocks

Despite banking’s dramatic recovery, Sharma is skeptical about whether the sector’s broad-based gains will continue. He points out that the largest players, like JPMorgan JPM (up 15% since the beginning of the year), Bank of America BAC (up 9%), or Wells Fargo WFC (up 16%), are trading close to their Morningstar-assessed fair values. He’s unsure what the Fed could do to prompt another big rally. “All those positive scenarios are already baked into the prices. Their profitability is strong, they’re doing well,” he says. They may see gains for a little while longer, but eventually, “things will normalize.”

For that reason, strategists recommend investors look to quality bank names rather than the sector as a whole. Sharma points to some regional bank stocks as potential value plays, but he cautions that they tend to be less diversified than the giants of the industry. As a result, they can be more sensitive to disruptions like losses in commercial real estate.

Baldi also sees opportunities: “There are a lot of nuances within the space, but there is room for reasonably valued, well-run companies with strong balance sheets that will fare relatively well, regardless of what the macro presents.”

What About NYCB and Commercial Real Estate?

One particular regional bank has captured the market’s attention this year: New York Community Bancorp NYCB. The bank saw its stock plummet some 40% at the end of January after reporting a surprisingly large loss for the fourth quarter (driven in large part by losses in commercial real estate) and reducing its dividend while setting aside even more money for future losses. The turmoil has continued this month as the company replaced its CEO, disclosed faulty internal controls, and said last year’s losses were significantly larger than it originally reported.

Morningstar strategists don’t think NYCB’s challenges apply to banks as a whole, even though the stock’s fluctuations are spreading to others. “New York Community Bank was in a uniquely risky position,” Morningstar chief US market strategist Dave Sekera said last month, explaining that larger banks and most other regional banks don’t have the same exposure to risky commercial real estate.

“We don’t see systematic risks this time around,” Sharma says. If NYCB developments cause the entire sector to sell off, he adds, “it’s an opportunity to buy.”

What About Interest Rates?

The biggest question mark for financial markets this year is monetary policy, and bank stocks are no exception.

“Optimism or pessimism about the space is mostly predicated on your view for what the Fed is going to do with interest rates,” Baldi says. On Wednesday, the Fed left interest rates unchanged but continued to allude to the possibility of several cuts later this year.

In general, high interest rates tend to be a tailwind for banks. When rates are higher, banks can charge customers more interest on loans and earn more on their investments while the interest rates they pay depositors remain relatively low. High rates also tend to coincide with strong economic growth, which means more demand for a bank’s products.

When rates fall, the spread between what banks earn and what they pay their customers shrinks, which tends to be bad for their bottom lines.

Sharma says this upcoming cutting cycle will likely be an exception, thanks to an unusual dynamic created by the fiscal stimulus in the wake of the covid-19 pandemic. Many financial institutions locked in long-duration investments (treasuries, mortgages) when rates hit rock-bottom levels. Sharma says that because those low yields are fixed, many banks’ balance sheets won’t take as much of a hit when rates start to fall, at least at the beginning of the easing cycle. The exception would be a swift series of cuts from the Fed, which would be negative for the sector overall.