The Big Bank Rally Has Only Just Begun
Leading bank stocks are up 10% to 25% in the past six months, but they should have a lot farther to go
By Michael Sivy

(MONEY Magazine) – When I've written about undervalued stocks over the past couple of years, I've usually included at least one of the big banks. Stocks such as Citigroup and J.P. Morgan Chase have long looked like bargains, with low price/earnings ratios, long-term potential earnings growth of 10% or more and high dividend yields. Nonetheless, the big banks have lagged the rest of the market--until last fall, when they started to rally. Now some investors seem to think the move is already over. A few analysts have even downgraded the sector from buy to hold.

That sure looks shortsighted to me. The big banks may never offer the chance to cash out at the peak prices that tech stocks reach from time to time. But what matters far more for long-term investors is a predictable 3%-or-better dividend rolling in, along with price appreciation that comes from steady earnings growth. By that standard, bank stocks still offer you the chance to make good money.

Banks Are Still Cheap

Even with their recent gains of 10% to 25%, banks are well behind the S&P 500, as you can see in the chart at right. Bank stocks usually perform badly when short-term interest rates are rising, and that has been the main trend ever since former Federal Reserve chairman Alan Greenspan began hiking rates in June 2004 to head off inflation. As a result, the difference in yield between the short-term Treasury bill and the 10-year Treasury bond--normally two to three percentage points--is now just a fraction of a point. It's tough for a bank to make a lot of money when its short-term borrowing costs are so close to what it can earn by lending money out for long periods.

Historically, though, most of the damage to bank stock prices occurs while short-term rates are rising. Assuming that there isn't a recession, the stocks' performance typically improves once it's clear that short-term rates aren't going any higher.

We're not quite at the end of the rate increases. The Fed, under new chairman Ben Bernanke, raised rates in March, and most Fed watchers expect a repeat in May. But there's a limit to how much Bernanke can boost rates, unless he wants to slam on the economic brakes.

And the Fed chairman doesn't seem worried about a runaway economy that could trigger a resurgence of serious inflation. The statement that accompanied the late March rate increase said, "Economic growth has rebounded strongly in the current quarter but appears likely to moderate to a more sustainable pace." It also went on to say that labor costs remain in check "and inflation expectations remain contained." Absent some surprise, that suggests to me that the economic environment for banks will probably look a whole lot better six months to a year from now.

CEOs with a Mission

My two favorites among banks today are Citigroup and J.P. Morgan Chase. In addition to the general case for banks I've outlined, they have their own particular reasons to look forward to higher profits. Both expanded rapidly in the past decade and now have CEOs who understand the need to focus on improving profitability rather than making more big acquisitions.

Citigroup is the largest financial services company--with brokerage, investment banking, credit cards and all kinds of lending. That rich mix of businesses is the legacy of former CEO Sandy Weill's dealmaking. But since October 2003, Chuck Prince has filled the CEO slot. A detail-oriented lawyer, Prince has been streamlining the company. Last year he sold Travelers Life & Annuity to MetLife and swapped most of Citigroup's asset-management business for Legg Mason's brokerage and investment banking operations. He then sold the latter. From here on, Citigroup's increasing profitability looks to come more from judicious trimming than from further high-profile acquisitions.

J.P. Morgan Chase is much less profitable than the other banking giants. But the new CEO, Jamie Dimon, who joined when the company bought Bank One in 2004, is working aggressively to change that. Today's JPM is a conglomeration of six banks acquired since the late 1980s and never really completely merged. But Dimon, known for his bluntness, has been forcing them to integrate. Where there were still multiple computer systems, for instance, he has insisted on common platforms. He has also forced divisions to work together more and remains on the lookout for smart deals. If Dimon can boost returns closer to the industry average, JPM's stock will prove to be the kind of investment you can bank on.

A LONG CLIMB BACK

Tough CEOs should propel shares of J.P. Morgan Chase and Citigroup, which are way behind the S&P 500.

GROWTH OF $100 INVESTED TWO YEARS AGO

S&P 500 $117.47

J.P. Morgan Chase (JPM) $102.08

Citigroup (C) $95.17

NOTE: Weekly data as of March 27.

SOURCE: Thomson/Baseline.

Read editor-at-large Michael Sivy online every Tuesday at money.com/sivy. E-mail him at msivy@moneymail.com.

Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.
Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.