Can the Bank Stock Rally Continue?

Bank Stocks have been impressive performers since the November election, with the Zacks Major Banks industry up +14.5% since November 8th, more than double the S&P 500 index’s +5.7% gain since then. Performance of some of the major banks like Bank of America (BAC: up +33.4% since November 8th), JPMorgan (JPM: up +23%), Citigroup (C: up +23%), and others has been even more impressive.

The immediate catalyst for this outperformance is the uptrend in interest rates, with the 10-year Treasury yield jumping more than 50 basis points since November 8th. Interest rates are like oxygen for banks, with low interest rates over the last few years as a result of deliberate Fed policy putting a lid on banks’ earnings power. Net interest margin, the difference between what banks pay their depositors and what they charge lenders, has been flat to down for the last few years. With revenue growth hard to come by as a result of this backdrop, banks were forced to maintain profitability by squeezing expenses out of their operations. Many in the market see this unfavorable run finally coming to an end, with interest rates steadily going up this year and beyond.

The likelihood of higher interest rates going forward isn’t the only bright spot for bank stock investors. Hopes remain high that the incoming administration will roll back all or most of the regulatory constraints resulting from the Dodd-Frank and other measures. Corporate tax reform is another potentially positive for the space as is the expectation of an elevated growth trajectory for the U.S. economy. All in all, the industry’s operating and regulatory outlook has never been this favorable in a long time. This has started showing up in bank stock EPS estimates as well, though the impact is most pronounced in expectations for the outer periods.

The chart below shows the stock price performance of the Zacks Major Banks industry (dark blue line) and how aggregate annual earnings estimates for the space have evolved lately. The notable element in this chart is the evolving picture for 2018 estimates (the red line whose recent portion has been highlighted). As you can see, estimates for 2017 have stabilized while the same for 2018 have notably turned around recently and started going up.

What Are Banks Expected to Report or Q4?

With Bank of America, JPMorgan and Wells Fargo reporting Q4 results this week (all reporting on January 13th), it will be interesting to see what they have to say about this changed operating environment. December-quarter EPS estimates for JPMorgan have moved up in recent days, though the same for Wells and Bank of America have been fairly stable.

For the Finance as a whole, of which the Major Banks industry is the biggest earnings contributor, total Q4 earnings are expected to be up +10.7% from the same period last year on +2.2% higher revenues. This would follow +12.3% earnings growth in Q3 on +4.9% higher revenues.

Easy comparisons at AIG (AIG) are a big contributor to the sector’s strong expected growth in Q4; the insurance giant is expected to report a roughly +2.5 billion swing in profitability from the year-earlier level. Excluding the easy comparisons at AIG, total Finance sector earnings would be up +5.4% from the same period last year.

The table below shows the sector’s Q4 earnings growth expectations at the medium-industry level contrasted with estimates for the following four quarters and actual results for the preceding three periods.

Please note that the Major Banks industry, of which JPMorgan, Bank of America and others are part, accounts for roughly 45% of the sector’s total earnings (insurance is the second biggest earnings contributor, accounting for about 25% of the total).

The sector’s earnings are on track to be flat in 2016. But they were expected to be up materially in 2017 and 2018 even before the aforementioned favorable developments. The chart below shows the sector’s annual earnings growth expectations.

With a number of policy oriented developments still to unfold after the new administration takes office, it is reasonable expect positive revisions to these expectations. And if that is the case, then bank stocks should continue their momentum. Valuations have no doubt caught up with underlying fundamentals, but they are by no means stretched relative to historical periods, particularly given the emerging interest rate trajectory.

Q4 Expectations As a Whole

The Q4 earnings season doesn’t take the spotlight for a few more days, but the reporting cycle has actually gotten underway already. We now have Q4 results from 21 S&P 500 members that get counted as part of the Q4 tally. All of these results are from companies reporting November fiscal quarter results. It is still too early to draw any firm conclusions from what we have thus far.

For Q4 as a whole, total earnings for the S&P 500 companies are expected to be up +3.1% from the same period last year on +3.9% higher revenues. This would follow the +3.8% growth in Q3 earnings on +2.3% higher revenues, the first instance of positive earnings growth for the index after five quarters of back-to-back declines. Comparisons for the Energy sector, a big driver of the earnings recession, turn positive in Q4, with the sector’s earnings growth turning positive for the first time after 8 quarters of declines.

The chart below shows the Q3 earnings growth contrasted with declines in the preceding 5 quarters. As you can see in the chart below, the growth pace is expected to ramp up in 2017.

The table below shows the summary picture Q4 contrasted with what was actually achieved in the preceding quarter.

Estimates for Q4 have come down since the start of the period, with the current +3.1% growth rate down from +5.5% at the start of the period. This isn’t unusual; we have been seeing this trend play out quarter after quarter for almost three years now. That said, the magnitude of negative revisions to Q4 estimates is lower relative to the comparable periods in other recent quarters.

In other words, estimates for Q4 came down, but they didn’t come down as much as was the case in the comparable periods in other recent quarters. It will be interesting to see if this trend will get repeated with 2017 Q1 estimates, as companies report Q4 results and share their outlook for Q1. We will find out in the coming days as the Q4 reporting cycle ramps up.

The chart below shows the weekly reporting calendar for the Q4 earnings season. We have a total of 29 companies reporting results this week, including 8 S&P 500 members.

Note: Sheraz Mian heads the Zacks Equity Research department and is a well-regarded expert of aggregate earnings. He is frequently quoted in the print and electronic media and publishes the weekly Earnings Trends and Earnings Preview reports. If you want an email notification each time Sheraz publishes a new article, please click here >>>

Here is a list of the 29 companies reporting this week, including 8 S&P 500 members.

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