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How bank stocks could weather a rate hike from the Federal Reserve

The fate of U.S. bank stocks took an interesting twist Friday, when the market plunged 2.5%, its worst one-day dive since late June. While analysts say a Fed rate hike and higher rates overall would be welcome news for banks’ battered bottom lines. USA TODAY

The fate of U.S. bank stocks took an interesting twist Friday, when the market plunged 2.5%, its worst one-day dive since late June. Sparking the market’s distress, after a long stretch of  summer calm, was a speech from Federal Reserve Bank of Boston president Eric Rosengren that suggested the nation’s central bank could hike interest rates soon.

While analysts say a Fed rate hike and higher rates overall would be welcome news for banks’ battered bottom lines, the specter of of higher borrowing costs slowing economic activity was viewed as trouble for most sectors.

But barring a broad stock market decline, bank stocks could perform better than the Standard & Poor’s 500 index as they did last month. In August, the KBW Nasdaq Bank Index, made up of 24 big banks, including Bank of America, Citigroup, JPMorgan and Wells Fargo — gained nearly 7%, vs. a fractional loss for the broad market gauge.  The bank index, however, is down 2.1% in 2016, vs. a 4.1% gain for the S&P 500.

Here are a few things working in bank stocks’ favor:

* Higher rates, bigger profits. Banks do better when interest rates are higher, and fare best when the “spread” between short-term rates and long-term rates widens.

If a bank pays out a miserly 0% interest on checking account deposits, but short-term rates set by the Fed are zero, the bank makes no money. But if a bank charges a home buyer 4% for a 30-year mortgage and pays out 0% in interest to depositors it pockets the 4 percentage point spread. If long-term rates rise further, and the bank can charge, say, 5% for a mortgage, its spread — or profit — grows to 5 percentage points.

“Any increase in rates from the Fed would boost earnings estimates for banks,” says Fred Cannon,  director of research at Keefe, Bruyette & Woods.

* Lower P-Es, better value. Many Wall Street pros say the U.S. stock market is overvalued by a common metric: the price-to-earnings ratio, or PE. But bank stocks are cheaper relative to the market. After Friday’s stock selloff, the S&P 500 was trading at 18 times its 2016 estimated earnings, compared to an earnings multiple of less than 14 for the KBW Nasdaq Bank Index, Cannon noted.

“When you look at other segments of the market, the banks are certainly in the cheaper tranche,” says Chris Verrone, a partner at Strategas Research Partners. Bank stocks could see fresh, sizable cash flows into the sector if the rally continues. Last month, $1.2 billion flowed into financial funds, the most in 10 months, Bank of America Merrill Lynch says.

* Past laggard, future leader. Investors are also emboldened when they see bank stocks fare better than the S&P 500 on a big down day like Friday. While the broad market fell 2.5%, the KBW Nasdaq Bank Index fell just 1%. On top of that, 94% of bank stocks have posted better returns than the S&P 500 over the past 30 days, says Verrone.


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