April 20, 2015

Bank shares could outperform

Over the last several years, the banking industry has been encumbered by the expenses associated with regulation and fines, tepid loan demand and historically low interest rates (and contracting net interest margins).

As well, Dodd-Frank has mandated a reduction in leverage, which, in part, has laid the groundwork for a multiplier-less recovery in which the Fed's injections of liquidity have not found their way into lending.

These conditions have weighed on banking industry valuations. But with rates likely bottoming and legal expenses and fines slowing down, I have argued that a healthy cocktail of expanding net interest margins and lending are about to be served up. 

Importantly, of late both M2 growth and velocity have begun to turn up. At the same time, commercial and industrial loan growth has begun to accelerate. This increased lending is getting little attention and bank stocks have been laboring. That lending rise is also having a positive multiplier effect on the money supply, which has begun to accelerate over the course of this year.

M2 (year over year) is now increasing at a rate of more than 6%. The 13- week rate of increase is even better at 7.2%, which is positive for the economy and banking. 

With most of the drop in energy prices and the strong U.S. dollar having run its course, the system is primed with money and M2 growth and velocity should start to increase.

In this setting, bank profits should expand nicely and bank shares could embark on a lengthy period of outperformance.