Bank stocks are among the companies that could benefit the most from the new federal tax law that cuts the corporate tax rate from 35 percent to 21 percent.
The biggest boost could come to banks that operate domestically and face hefty tax burdens that will be eased under the new law. Banks also offer appeal to investors because rising interest rates could allow financial institutions to hike their net interest income, which is the spread between what they charge to borrowers compared to the interest they pay to depositors.
One broad-based bank fund that investors can buy to tap the opportunity to profit from the new tax law is SPDR S&P Bank ETF (NYSE:KBE), which seeks to provide investment results that correspond to the total return of the S&P Banks Select Industry Index. Two of the most compelling aspects of KBE are its price-to-earnings (P/E) ratio of 13.97, compared to P/E ratios of 24.69 for the Dow Jones industrial average and 24.46 for the S&P 500, and a modest gross expense ratio of just 0.35 percent.
The exchange-traded fund (ETF) also offers a current dividend yield of 1.34 percent for investors who seek income, along with potential share-price increases. KBE features 76 holdings in its portfolio, which largely consists of regional banks.
S&P Banks Select Industry Index Top Holdings
As of 02/12/2018
|Popular Inc.||2.03 %||2,158,585|
|LendingTree Inc.||1.99 %||240,724|
|Comerica Incorporated||1.97 %||887,978|
|Regions Financial Corporation||1.95 %||4,439,770|
|Signature Bank||1.95 %||551,254|
|M&T Bank Corporation||1.94 %||441,567|
|PacWest Bancorp||1.94 %||1,565,882|
|Bank of America Corporation||1.93 %||2,610,364|
|BB&T Corporation||1.91 %||1,522,450|
|East West Bancorp Inc.||1.91 %||1,256,491|
Source: State Street Global Advisors
KBE became a recommendation in the Successful Investing newsletter last Oct. 30. The view of Jim Woods, its editor, is that markets regard tax cuts as “reflationary,” since they tend to heighten wage and price increases.
Anything that even hints at fueling what until recently had been a benign inflation rate could spark the reflation trade and prod fixed-income traders to sell, as rising interest rates hurt bond prices. KBE and other bank-related investments also should be aided by improving economic growth rates that may spur borrowing before interest rates rise much.
Plus, the U.S. economy grew 3.2 percent in the third quarter of 2017 to follow 3.1 percent growth in the second quarter of 2017, marking the first time that gross domestic product (GDP) climbed at least 3 percent for two consecutive quarters since the same two periods of 2014. The pace of GDP growth slipped slightly to 2.6 percent in fourth-quarter 2017 but still shows an increase from the previous two years.
Woods said reflation would be confirmed by a move above 100 in the KBW Bank Index (BKX), as well as a sustained rise above 2.40% in the 10-Year Treasury Note Yield, which both occurred late last year. With data confirming reflation, he recommended two bank-related investments, including one leveraged fund, ProShares Ultra Financials (UYG), which he advised selling on Monday, Feb. 12, to take profits of 18.77 percent.
UYG seeks to track the performance of twice the daily results of the Dow Jones U.S. Financials Index, so it carries greater risk and reward than KBE. With a gross expense ratio of 0.96 percent, UYG also has expenses that are nearly three times those of KBE.
The new 40 percent reduction in corporate taxes would enhance the profits of financial institutions such as Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM) and Wells Fargo & Company (NYSE:WFC). Banks also should benefit as companies that currently hold funds overseas repatriate money to deposit or to use in the United States. One byproduct could be additional mergers and acquisitions activity, which also would be positive for banks.
Bank of America is expected to add $2.7 billion to its profits this year due to the tax cut. As its name implies, Bank of America also is focused on serving the United States more than other big financial institutions that tend to have comparatively larger portions of net interest income produced from outside the country.
In addition, Bank of America currently yields 1.58 percent, so it gives shareholders a bit of income to go with any capital appreciation it produces from increases in its share price. The bank’s P/E ratio of 19.84 falls below the P/E ratios of the Dow and S&P 500 but above the P/E ratios of 17.64 for JPMorgan Chase & Co. (NYSE:JPM) and 13.82 for Wells Fargo & Company (NYSE: WFC). The yields for JPMorgan Chase and Wells Fargo are 2.04 percent and 2.82 percent, respectively, which top the yield of Bank of America.
Now could be a good time to buy shares in a bank fund or a bank, after the recent market drop and increased volatility. The Dow’s 1,175-plus-point pullback on Feb. 5 — the largest point-plunge in history — led to a 4.6 percent drop that day. All 11 sectors in the S&P 500 fell, with large lenders, as represented by the KBW Nasdaq Bank Index, down 4.9%.
Keep in mind that banks are subject to credit risk. So, if interest rates keep rising and borrowers that have variable rate loans struggle to make payments, the same financial institutions that seem worthy of investment now should be monitored to ensure any increases in “non-performing” loans are manageable. Banks have “recovered” from the Great Recession that began in December 2007 and lasted until June 2009, when real gross domestic product fell 4.3 percent, said Bert Ely, a banking consultant who heads Ely & Co., of Alexandria, Virginia.
“Most banks have strong capital positions,” Ely added.
The economy’s quickened pace of growth in the past several quarters and the much-improved capital position of banks since the Great Recession, as well as their modest valuations, should give investors seeking exposure to financial services a chance to find something to buy at a discount after the recent market retreat.