NEW YORK ( TheStreet) -- It's been a banner two-year run for bank stocks but, although the economy is expected to continue to improve, this year's high flyers may not be winning picks for 2014.
The KBW Bank Index ( I:BKX) has risen 30% this year, following a 30% gain during 2012. All 24 components of the index have seen year-to-date returns -- assuming the reinvestment of dividends -- of at least 20%, except for Northern Trust ( NTRS) of Chicago, which was up 17% through Wednesday's close at $57.17, and M&T Bank ( MTB) of Buffalo, N.Y., which was up 19% to $113.81.
"One might look at the outperformance over the past two years and suggest a pull-back or consolidation of the gains is warranted. However, the solid outperformance (in a vacuum) does not necessarily mean the large cap banks are now overvalued," according to KBW analyst Christopher Mutascio.
There are several factors leading to a prediction by Mutascio that large-cap banks covered by his firm will see core earnings-per-share growth of just 2% during 2014, slowing from an estimated 16% this year. For starters, the release of excess loan loss reserves that has been boosting earnings over the past several years is expected to slow, as is the rate of expense decline as loan servicing and other credit-related costs go down. Another year of slowing mortgage refinance applications, brought about by a rise in long-term interest rates is also expected to slow overall mortgage fee revenue.
Despite the rise in long-term interest rates, most market watchers expect the Federal Reserve to keep the short-term federal funds rate in a target range of zero to 0.25% at least until 2015. For most banks, this means a continuation of a hostile rate environment and pressure on their net interest margins.
"It is clear that 2013 has been the year for low [price-to-tangible-book-value] P/TBV bank stocks," Mutascio wrote Wednesday in KBW's 2014 Outlook for large-cap bank stocks. "Within [Mutascio's coverage of 11 large-cap U.S. banks], the top four banks with the greatest year-to-date returns all have at least one thing in common -- they have P/TBV multiples that are below the group's average," the analyst wrote.
According to Mutascio, based on Monday's closing market data, KeyCorp ( KEY) of Cleveland, Huntington Bancshares ( HBAN) of Columbus, Ohio, Regions Financial ( RF) of Birmingham, Ala., and Bank of America ( BAC), "saw an average year-to-date return of 41.9% versus the average return for the remaining seven banks under our coverage of 27.3%. So, the low P/TBV stocks thoroughly outperformed the broader market return of 26.8% while the average returns of the remaining banks has been pretty much in line with the S&P 500."
A major catalyst for the big banks over the past two years has been investors' believe that the stocks were just too cheaply valued, since the credit crisis was coming to an end.
"With the banks already trading above their 18-year norm relative to the S&P 500 and outperforming nicely the past two years, what would cause further outperformance for the group in 2014? In our view, the catalyst for continued outperformance would now have to come from growth (not valuation), which leads us to the second reason why we think bank stock outperformance is less likely in 2014."
The four banks listed above outperformed in 2013, in part, because they traded cheaply to tangible book value at the beginning of the year. But KBW expects them as a group "only" to generate returns on average assets (ROA) of 0.98% and returns on tangible equity (ROTE) of 10.6% by 2015. "Conversely, the remaining seven [large-cap banks covered by Mutascio] are expected to generate average ROAs and ROTEs of 1.27% and 13.8%, respectively, and yet they trade at an average P/E multiple discount of approximately 7%.
Mutascio recommends investors take a neutral stance on large-cap banks for 2014, "with rotation out of the low price-to-tangible book value (P/TBV) outperformers and into the higher profitable laggards for value hunters in a space that is no longer cheap."
Out of 11 large-cap banks covered by the analyst, Rates only two "outperform."
Shares of JPMorgan Chase ( JPM) closed at $56.07 Wednesday, returning 31% this year. The shares trade for 1.5 times tangible book value, according to Thomson Reuters Bank Insight, for 9.3 times the consensus 2014 Earnings estimate of $6.01 a share, and for 8.8 times the consensus 2015 EPS estimate of $6.36. That's the lowest forward P/E ratio for 2014 among the 24 components of the KBW Bank Index.
I's been a rough year for JPMorgan Chase, with a third-quarter net loss reflecting $9.15 billion in provisions for litigation reserves, followed this quarter by the landmark $13 billion settlement of residential mortgage-backed securities (RMBS) investigations and claims by the Justice Department and other government authorities, as well as a $4.5 billion RMBS settlement with a group of institutional investors.
JPMorgan on Dec. 4 was also slapped with $109 million in fines by the European Commission for its role as one of the banks participating in "bilateral cartels relating to interest rate derivatives denominated in Japanese yen."
The Wall Street Journal on Thursday reported that JPMorgan was "expected to pay more than $1 billion in penalties to the Justice Department to end a criminal probe into whether it provided adequate warnings about Bernard L. Madoff."
That brings the company's fourth-quarter litigation tab to at least $18.6 billion.
But JPMorgan had already set aside reserves to cover the bulk of those litigation costs.
"We continue to be amazed at the premiums investors are applying to asset-sensitive names for a potential catalyst (rising short-term interest rates) that may not occur for another two-plus years while at the same time they apply a substantial discount to JPM as if its legal costs will last forever," Mutascio wrote.
His price target for JPM is $63.00.
Shares of U.S. Bancorp ( USB) of Minneapolis closed at $39.04 Wednesday, returning 25% this year. The shares trade for 3.3 times tangible book value, for 12.2 times the consensus 2014 EPS estimate of $3.20, and for 11.3 times the consensus 2015 EPS estimate of $3.46.
USB has been the best earnings performer among the big U.S. banks for many years. The company's ROA for the first three quarters of 2013 was 1.66% and its return on average tangible common equity (ROTCE) was 24.18%, which was, by far, the strongest among the 24 components of the KBW Bank Index.
Mutascio's price target for U.S. Bancorp is $43.00. "Adjusting for HBAN's potential auto securitizations, we expect USB to post the best revenue growth in 2014 at just 2.1%," the analyst wrote.
The following chart shows the price performance for JPMorgan and U.S. Bancorp over the past five years, against the KBW Bank Index:
data by YCharts
-- Written by Philip van Doorn in Jupiter, Fla.