Bank of America analysts cautioned investors about the potential for an "overshoot" in the valuation of bank stocks as optimism builds around a soft landing for the U.S. economy and increased policy clarity following the upcoming U.S. elections.
According to Bank of America, the year-to-date performance of bank stocks has already validated their early 2024 view that stable-to-rising earnings per share (EPS) outlooks would drive a higher valuation re-rating for bank stocks.
Analysts explain that the trend has been reflected in the impressive gains across various bank categories: Mega-cap banks are up 19.8%, super regionals by 18.6%, trust banks by 10.9%, and small-to-mid-cap banks (SMID-caps) by 9.2%, compared to the S&P 500's 17.4% increase.
While the risk/reward profile for bank stocks is not as compelling as it was earlier in the year, Bank of America suggests that rising optimism and policy clarity could drive valuations even higher.
This potential overshoot should not be discounted by investors.
The upcoming August Non-Farm Payroll (NFP) report is highlighted as a critical indicator for the banking sector.
"An inline to better August jobs report on Friday could serve as an all clear for generalists to add exposure to bank stocks given the strong correlations between the unemployment rate and credit losses," analysts wrote.
Bank of America also notes that dedicated bank investors are particularly focused on downside risks from lower interest rates, while generalists are more concerned with credit quality and the potential for improved customer activity next year.
Historically, owning bank stocks heading into and after U.S. elections has almost always been rewarded, further underscoring the potential for a valuation overshoot, Bank of America concludes.