My late father had a lot of folksy sayings when I was growing up. One of his favorites was: "Life is like a pendulum. It swings too far to the left and it swings too far to the right, but it always ends up eventually in the middle." My dad also was a banker for 35 years -- back when banking was a noble, if boring, profession. Banks collected deposits and made loans and did little besides that. Bank stocks were mundane consistent performers, paid a nice dividend and were frequently found in "widows and orphans" portfolios. In short, they functioned like utility stocks do today. Times certainly have changed.
I was reminded of this the other day when I took a look at the Financial Select Sector SPDR (XLF) over the past five years and compared it to the Utilities Select Sector SPDR (XLU) over the same time period. Bank stocks cratered during the financial crisis and have roughly followed the performance of the utility index since the nadir of March 2009. Overall, the utility index has outperformed the financial services index by some 50% over the last half decade.
However, over the next five years I would not be surprised to see the total flipside for these indexes. Utility valuations are stretched with stalwarts like Consolidated Edison (ED - Get Report) selling at 16x earnings and at the top of its five-year valuation ranges based on P/B, P/CF, P/E and P/S. Meanwhile, bank stocks are going for 10x to 11x forward earnings and have better long-term growth prospects. Yields of 2% to 3% may not look enticing to income investors right now, but those are at very low payout ratios. As payout ratios drift back to the traditional 40% to 50% levels, yields on many bank stocks will be in the 3.5% to 4.5% range at current prices, comparable to utilities.
In addition, housing is the biggest source of collateral for bank loans, so as the housing market continues to improve, bank earnings likely will as well. Last, the Federal Reserve's QE efforts will eventually diminish and the yield curve will steepen. This will also be beneficial to bank's margins. So here are two of the largest residential lenders that I think will do very well over the next five years.