Why It's Time to Take Profits on Bank Stocks, Wells Fargo, Citi

NEW YORK (TheStreet) -- There seems to be a general consensus among market commentators and investors that rising interest rates will be good for U.S. banks. In anticipation, bank stocks like Bank of America (BAC) , Citigroup (C) , JPMorgan Chase (JPM) , Wells Fargo (WFC) and the Financial Select Sector SPDR ETF (XLF) have had a tremendous run over the past two years.

BAC Chart

BAC data by YCharts

It has been helpful that post-crisis litigation and fines seem to be in the rearview or at least out in the open, especially in the cases of Bank of America and JPMorgan. But the recent rally for the group may be more of an opportunity for profit taking than confirmation of a trend. 

First of all, the claim that rates are rising is debatable. Below is a chart reflecting the yield on the 10-year Treasury bond over the past decade. Opinions will differ -- but the downtrend appears firmly intact.

10 Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts

The only time rates have risen meaningfully in the past few years was immediately following Bernanke's infamous slap-on-the-wrist speech in May of 2013, warning investors that the quantitative easing spigot would assuredly not get stuck in the "on" position. This was six months prior to the Fed actually beginning to slow its bond-buying stimulus efforts.

Since Janet Yellen took over a year ago and QE has in fact been slowly and methodically withdrawn, rates have moved down across the board. Many investors banked too heavily on the Fed's role in keeping the long end of the curve down.

Similarly, when the Fed does eventually tighten it will be raising short-term rates, and there is no guarantee that the downward pressure on longer-term rates will not persist. Two major catalysts remain.

1. The search for yield is now global, and for "risk free" yield the U.S. Treasury Bond is the only game in town (where the "town" is Earth).

2. Dollar strength means other currencies weakening in relative terms; Treasuries need not move at all, necessarily, for foreign buyers to profit by owning them.

So what has prompted the rally in bank stocks?

Has it been the idea that there was nowhere else to go but up? The strengthening U.S. economy and housing market? The shoring up of balance sheets and the tightening of their lending standards?

Likely the artificially steep yield curve and the anticipation of higher rates are to thank. It's not consumers who get access to "0% interest rates" -- it's banks.

But what seems to be getting overlooked is the fact that the spread -- the difference between shorter and longer rates -- is starting to narrow, and in somewhat dramatic fashion.

10-2 Year Treasury Yield Spread Chart
10-2 Year Treasury Yield Spread
data by YCharts

Banks are no longer savings and loan institutions, and have diverse portfolios of businesses. But at their core they make money by borrowing on the short-end of the curve (at the Fed funds rate) and lending on the long-end (mortgages, commercial loans, etc.).

Over the last fifteen years, here is how the Financial Select Sector ETF has performed overlaid with the spread between the two-year and 10-year Treasury yield. You can see there is a bit of a lag in either direction, but the correlation is quite clear: a small spread is bad news for banks.

10-2 Year Treasury Yield Spread Chart
10-2 Year Treasury Yield Spread
data by YCharts

Not all banks are created equal

There are other factors influencing some U.S. banks. Bank of America and Citigroup are the most notable exceptions to the argument outlined here. The resumption of capital return programs (dividends and share buybacks) at these two may provide significant support for their shares in the face of headwinds.

Margin pressures on the group as a whole, though, may make for some unexpected turbulence at JPMorgan, Wells Fargo, and the Financial Select Sector ETF. Their respective dividends -- 2.80%, 2.70% and 1.50% -- do not adequately reward shareholders for risk that is yet to be priced in.

While it may seem counterintuitive, I think you want to buy or hold Bank of America and Citigroup in anticipation of imminent improvements to their dividend and share buyback programs. On the contrary, JPMorgan, Wells Fargo and the Financial Select Sector ETF seem priced for perfection. Consider taking profits here.

At the time of publication, the author held no positions in any of the stocks mentioned. He is long BAC in client accounts.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.


TheStreet Ratings team rates JPMORGAN CHASE & CO as a Buy with a ratings score of A. TheStreet Ratings Team has this to say about their recommendation:

"We rate JPMORGAN CHASE & CO (JPM) a BUY. This is based on the convergence of positive investment measures, which should help this stock outperform the majority of stocks that we rate. The company's strengths can be seen in multiple areas, such as its increase in stock price during the past year, expanding profit margins and attractive valuation levels. We feel these strengths outweigh the fact that the company has had sub par growth in net income."

You can view the full analysis from the report here: JPM Ratings Report

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