Is Now the Time to Buy Bank Stocks?

Bank stocks haven’t exactly been market darlings in recent years. The financial services sector has a Shiller price-earnings ratio of 21 as of the writing of this article, which is the lowest among the 11 market sectors tracked by the S&P 500. The sector’s regular price-earnings ratio stands at 12.6, which is below all but the energy sector (the energy sector’s regular price-earnings ratio cannot be calculated because the average earnings for these stocks are negative).

There are good reasons why banks typically trade at lower valuations compared to many other sectors. For one, their growth is fairly slow, so most investors see better growth opportunities elsewhere. Their earnings also tend to be more predictable than those of most companies, so there is not much hope for an earnings surprise. Thus, these stocks don’t typically get to benefit from elevated valuation multiples.

Banks have also seen their traditional income stream, interest income, dry up over the past couple of years due to the U.S. Federal Reserve’s easy-money policies. While may larger banking institutions, especially JPMorgan Chase & Co. (

JPM, Financial) and Bank of America Corp. (BAC, Financial), have managed to make up the difference through their investment banking arms, that hasn’t been the case for many smaller players.

However, the situation could be turning in favor of banks. In its policy meeting this week, the Fed announced that it plans to accelerate the tapering of its bond-buying program, and in 2022, it aims to make three rate hikes, marking a bigger change in stance than what analysts were expecting. Rising rates means more interest income for banks, which begs the question: is now the time to pick up bank stocks, before interest rate hikes deliver growth?

Higher interest ahead?

Nearly all of the banks in the U.S. saw their net interest income decrease in 2020 due to base interest rates being dropped to zero. Even though there was a significant uptick in borrowing, it wasn’t enough to make up for the rock-bottom rates.

Moreover, businesses were nowhere near as reliant on banks in the 2020 recession as they were in historical recessions. Many of those who would have gone to banks or even investors for business loans in the past managed to get free money from taxpayers (via the government) in the form of bailouts or the Fed’s bond-buying program.

Even with base rates near zero, bank majors still managed to return to year-over-year growth in net interest income in the third quarter of 2021, but this may have had more to do with accounting tricks than with an actual increase in net interest income. For example, on Bank of America’s third-quarter earnings report, it states the following:

“Net interest income (NII) up $1 billion, or 10%, to $11.1 billion, driven by strong deposit growth and related investment of liquidity, and Paycheck Protection Program (PPP) activities.”

In other words, the increase in interest income included the benefits of the bank having more deposits to invest, as well as interest collected on PPP loans. The six U.S. bank majors were responsible for distributing the majority of PPP loans, and the only one that wasn’t allowed to profit off of the program was Wells Fargo & Co. (

WFC, Financial), which was again being penalized for its fake accounts scandal back in 2016.

The Fed’s announcement of rate hikes on the horizon could mark the light at the end of the tunnel for banks. With their loan portfolios and deposits having expanded over the course of the pandemic, these financial institutions are well positioned to reap the benefits of monetary policy returning to the route that has made them so profitable in the past.

On the other hand, the rate hikes might not be enough for banks to report more than mediocre growth. Interest rates in the U.S. have also been on a long-term downtrend since the ’80s, and some speculate that policymakers could eventually move in the same direction as the European Central Bank and introduce negative interest rates in the next recession.

The problem of inflation

In addition to the potential for interest rate hikes to be reversed in the next recession, there are also the effects of inflation to consider. Inflation benefits existing borrowers by decreasing the value of the dollars that they use to repay their loans. This is one of the key reasons why borrowing money to purchase assets is often more economically advantageous than renting them; in the future, when the prices of those assets rise, the borrower is the one who will benefit from price increases, not the lender.

However, inflation is not that simple. New borrowers will have to pay higher interest rates when rates are hiked, which benefits borrowers. Interest income can also increase if wages rise at a slower pace than prices, as many people will have to stretch out their loans over a longer period of time. This can easily backfire if borrowers become unable to pay back their loans and default rates rise.

All in all, inflation is a double-edged sword for banks, and everything evens out over time for the most part.

Investors aren’t sold just yet

Even though upcoming interest rate hikes are good for banks, investors don’t seem sold on the prospect. The S&P 500 gained 1.63% on Wednesday following the news of the Fed’s planned rate hikes, but bank stocks were not among the beneficiaries of the impending policy changes.

Below is the aggregate chart for the S&P 500, which shows the distribution of price changes in the index for the day:

As we can see, the majority of S&P 500 stocks booked at least some minor gains for the day. The U.S. bank majors, however, were among the few losers of the day, with Bank of America down 0.43%, JPMorgan down 0.75% and Citigroup Inc. (

C, Financial) down 0.66%. Wells Fargo was up a bit for a 0.05% gain.

Returns still rely on dividends

Rate hikes will be good for banks, but the overall outlook for the sector seems mixed. Therefore, the main source of returns from bank stocks will likely continue to be dividends. Their steady and predictable growth means that well-run banks can provide strong and reliable dividends and grow them alongside broader economic growth.

Dividends are one of the reasons why institutional investors are so fond of bank stocks.

Warren Buffett (Trades, Portfolio)’s Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial), for example, owns 12.34% of Bank of America’s total shares outstanding. Those shares were purchased for an average price of about $25, pushing the current yield above 3% for the Oracle of Omaha, although those buying now would only get a 1.78% dividend yield.

Those interested in banks that can benefit from rising interest rates may want to focus their attention on those that are well-run and pay market-beating dividend yields. There won’t be any high-growth tech stocks among these names, but they can be a safe place to park cash if you want more of your portfolio to be low risk.