There are several reasons why the financial services sector is struggling this year. Bank of America (NYSE:BAC) is not immune to this trend. Year-to-date, BAC’s stock is down about 27% while the S&P500 is up 3.53%.
Low interest rates alone, which BAC shares were facing entering 2020, are a drag on bank stocks, as these low rates suppress banks’ net interest margins. It is the spread on loans made by lenders and what is paid in interest to depositors. For those who prefer a simpler explanation, financials is a sector that has always done well when the Federal Reserve is tightening, not loosening.
What further afflicts the sector is why the Fed has cut rates to near zero. The culprit is, of course, the novel coronavirus pandemic. The US economy deteriorated rapidly in the first quarter, prompting the Fed to cut rates to historic lows. The low rates were bad enough for bank stocks, but the slowing economy was worse as it forced banks to set aside more cash to cover bad debts.
There is hope for BAC Stock
Add to that the fact that earlier this year the Fed told banks not to raise dividends and forced a halt to buybacks, and it’s easy to see why investors are frustrated with the big banks. Fortunately, there is light at the end of the tunnel with Bank of America.
The bank’s provision for loan losses in the second quarter, although slightly above the level of the first quarter, was well below increases at its competitors JP Morgan (NYSE:JPM) and Wells Fargo (NYSE:WFC). Specific to the latter, it is clear that in the short to medium term, Bank of America is the best choice for investors. Those who need convincing for this purpose should consider that Warren Buffett’s speech Berkshire Hathaway (NYSE:BRK.ANYSE:BRK.B) is reduce its stake in Wells Fargo while increasing exposure to BAC.
Second, there are indications that the amount of cash spent on bad debts peaked in the second quarter. Many banks have been overly cautious in building these reserves in the first six months of 2020. This is important because if the economy improves and loan loss rates are not as bad as expected, financial companies like Bank of America can convert the unused part of these reserves into income.
In other words, Bank of America has some earnings firepower and could be deployed sooner than expected.
Investors considering bank stocks today need to be clear on one crucial factor: the Fed is making it clear that interest rates are unlikely to rise before 2023. So the catalyst for higher rates is not on the cards. for years to come for this sector.
This means that the bet investors are making with Bank of America is not so much based on monetary policy as it is on the US economy. As the unemployment rate and the number of Covid-19 cases and deaths decline, banking stocks should benefit, particularly if companies can convert loan loss reserves into profits.
That’s further away, but in a hypothetical scenario where a coronavirus vaccine is accessible and jobs are restored to the point that the unemployment rate is halved, the Fed might consider allowing Bank of America and friends increase shareholder rewards.
In the meantime, investors don’t have to pay to get involved with Bank of America, because during the second quarter more than half of the country’s banks traded below their tangible book value.
As of the date of publication, Todd Shriber had (directly or indirectly) no position in any of the securities mentioned in this article.
Todd Shriber has been an InvestorPlace contributor since 2014.