Core View: The stock price movements of U.S. banks are more influenced by valuation drivers than performance drivers. Valuation elasticity has a far greater direct impact on stock prices than fundamental elasticity—valuation determines whether prices rise and the absolute returns. Digging deeper, beneath the surface of valuation, the U.S. market prices bank fundamentals extremely efficiently. Which banks see valuation expansions, contractions, or larger price swings is closely tied to their fundamental trends. Fundamentals determine the extent of gains and relative returns. Additionally, the influence of valuation and fundamentals varies significantly across different phases. Investors must closely track fundamentals in each phase while accurately distinguishing between different stock price cycles to grasp stage-specific factors like valuation and market capitalization beyond fundamentals.
The report breaks down the U.S. banking sector's stock price rallies into valuation and fundamental factors, categorizing four typical phases based on combinations of these two drivers. Stock performance across phases ranks as follows: 1. Dual expansion in valuation and fundamentals > 2. Valuation expansion without fundamental improvement > 3. Fundamental improvement without valuation expansion > 4. Dual contraction in valuation and fundamentals.
**Valuation determines whether prices rise; fundamentals determine how much they rise**: While U.S. bank stock performance is more affected by valuation changes, the market prices fundamentals with remarkable efficiency. Across four historical cycles, fundamentals consistently dictated relative performance among individual stocks within the sector. Low valuation is also a key source of alpha, while market cap plays a critical role in extreme phases.
**Phase 1: Dual Contraction in Valuation and Fundamentals (Crisis Periods, Stability is Key)** Examples include systemic risks like the subprime crisis or the global pandemic. Within the sector, banks with more stable fundamentals saw smaller price declines. Among banks with similar fundamentals, those with lower valuations fell less. For banks alike in both fundamentals and valuation, larger market caps cushioned declines.
**Phase 2: Dual Expansion in Valuation and Fundamentals (Post-Crisis Recovery, Elasticity is Key)** This rare phase typically follows systemic crises (e.g., 2009–2010, 2020–2021). Banks with greater fundamental improvements and lower valuations outperformed. However, smaller-cap banks led when either fundamentals or valuation was favorable—highlighting the market’s consistent pricing of fundamentals and valuation preferences but opposite reactions to market cap (i.e., price elasticity).
**Phase 3: Fundamental Improvement Without Valuation Expansion (Valuation Uplift Matters, But Fundamentals Dictate It)** Occurs when supportive policies persist but economic expectations remain divided (e.g., 2010–2012). Sector-wide fundamentals improved, yet valuations stagnated. Here, valuation uplift drove alpha more than earnings growth, with market cap losing significance. Two types of banks achieved valuation expansion: 1. Those with superior fundamental recovery (e.g., Western Alliance Bancorp, Truist). 2. Those buoyed by catalysts like M&A or high-profile investments (e.g., U.S. Bancorp, M&T Bank). Notably, banks lifting valuations via fundamentals typically started with low valuations, while event-driven ones didn’t always sustain outperformance.
**Phase 4: Valuation Expansion Without Fundamental Improvement (Fundamentals Drive Alpha)** Emerges when economic outlooks brighten but monetary policy or operating environments stall further bank tailwinds (e.g., 2012–2017). During sector-wide valuation expansions, fundamentals were the primary alpha driver, followed by low valuation; market cap had negligible impact. Banks with strong fundamentals offset high valuations, while trend reversals triggered underperformance. The best performers combined robust fundamentals and low valuations (e.g., Bank of America).
**Current Phase and Outlook** The U.S. banking sector is now in Phase 4 (valuation rising, fundamentals stable). Given economic resilience and upbeat earnings guidance, a plunge into Phase 1 (dual contraction) is unlikely. Phase 2 (dual expansion) remains improbable absent systemic shocks. Whether the sector stays in Phase 4 or shifts to Phase 3 hinges on valuation—largely tied to broader economic expectations.
**Investment Strategy: Balanced Offense and Defense** Historical analysis shows U.S. megabanks excel in Phases 3 and 4. Combined with current earnings guidance and valuations, they offer a balanced pick, especially those at historically low valuation percentiles. Beyond megabanks, lenders with sustained ROTE improvements are also attractive.
**Risks** 1. Worse-than-expected U.S. recession under potential Trump policies. 2. Aggressive Fed rate cuts pushing terminal rates below 3%, harming net interest margins. 3. Geopolitical shocks disrupting U.S. stability. 4. Tighter banking regulations on capital adequacy. 5. Any of these risks impairing asset quality or capital positions.
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