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Investors Are Finally Banking on Big Banks


Bank earnings that merely aren’t bad might not be good enough anymore.

There were many things working against U.S. lenders in the second half of last year: falling interest rates, sticky deposit pricing, tepid loan growth, uncertain changes in capital rules and choppy capital markets. It was all too easy to expect their performance to reflect that.

Lower rates did exact a toll in the third quarter, sharply compressing the core margin banks earned paying depositors and collecting interest. But strong trading revenue, a rotation into buying securities, a surge in cheap deposits and consumers’ continued credit binge helped banks escape the gravity of falling rates and produce solid earnings reports in the third quarter.

Investors have rewarded banks for defying gloomy expectations. From the 10th to the 30th day of the month that banks reported earnings for the last four quarters, the sector’s shares have outperformed the S&P 500 by on average nearly 4 percentage points, according to an analysis by Autonomous Research. This came despite the fact that analyst forecasts for 2020 were reduced each quarter, Autonomous noted. By the end of 2019, banks were among the market’s best performers: S&P 500 lenders rose 36%, ahead of the overall index’s 29% gain.

That jump has boosted valuations to lofty levels. Banks in the S&P 500 are trading on average at about 1.3 times their book values—just about the highest multiple at any time since the financial crisis. The last time the group was substantially above that level was early 2018, when markets were anticipating already rising interest rates to climb even higher—a huge tailwind for banks.

The upshot is that the expectations game may now be working against banks. With the market not forecasting another Fed rate cut until at least very late in 2020, the outlook for net interest margins has finally stabilized. In fact, five of the biggest banks, including

Bank of America,

have actually seen analysts’ 2020 “NIM” forecasts rise over the past month, according to FactSet.

Banks still have a few ways to surprise. For one, fourth quarter 2018 was dismal for trading desks, but the most-recent fourth quarter had a backdrop of rising prices, which generally boosts revenue.

Citigroup

said it expected a year-over-year trading revenue jump in the “high teens,” and Bank of America is anticipating high single digits.

Loan growth may also help paper over any further compression in net interest margin, especially for banks with giant card units such as

JPMorgan Chase

and Citigroup. Large banks’ loans to consumers grew 11.9% in the fourth quarter over last year, according to Federal Reserve data.

It might not be quite the same story for regional banks, though, as many are weighted toward commercial and industrial lending. Such loans at big banks grew 3.5% over the quarter, but had a negative week of year-over-year growth in late December for the first time since 2011, according to Fed data. Regionals now are trading at a price-to-earnings discount to bigger banks for the first time since 1996, analysts at Goldman Sachs Group noted.

But investors shouldn’t be tempted to simply chase the lowest valuations. What long-term investors should be focused on are finding banks doing more than just playing the best defense against low rates. Lenders that can decouple from the rate cycle by showing big gains in expense efficiency, particularly through technology investment, will be the ones that ultimately prevail in the expectations game.

Write to Telis Demos at telis.demos@wsj.com

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