These banks are solid and cheap. But here’s why investors should be cautious

By ReportWire Aug 22, 2023 · 1:57 PMUpdated Aug 22, 2023 · 4:41 PM 5 min read

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With the banking sector facing a myriad of crosscurrents — including stricter government regulations, higher interest rates and scrutiny from U.S. rating agencies — financial stocks are looking cheap. But the Club is exercising caution when it comes to our two bank names: Wells Fargo (WFC) and Morgan Stanley (MS). The KBW Bank Index , a benchmark stock index of the banking sector, has fallen more than 26% over the past six months amid ongoing investor unease following the collapse of Silicon Valley Bank in March. Shares of Wells Fargo and Morgan Stanley have lost 8.52% and 13.73%, respectively, during the same period. Although both firms have solid fundamentals and are affordable at current levels, we can’t recommend investors buy up more shares at this time given continued uncertainty over the health of the broader financial-services industry. “I can’t tell you to pull the trigger just yet [even] when both Wells Fargo and Morgan Stanley are as cheap as all get out,” Jim Cramer said during the Club’s August Monthly Meeting . Banking backdrop When Silicon Valley Bank and other regional lenders were forced to shut their doors earlier this year, the U.S. banking sector faced its biggest crisis of confidence since the 2007-2009 global financial crisis. Tremors spread globally, with UBS Group (UBS) forced to take over embattled Swiss lender Credit Suisse a few months thereafter. Banks are also operating in a high-interest-rate environment. To combat decades-high inflation, the Federal Reserve has delivered 11 rate hikes since launching a monetary-policy-tightening campaign in March 2022. The central bank’s latest 25-basis-point hike last month took benchmark borrowing costs to their highest level in more than 22 years . To be sure, higher rates can be beneficial for banks. Profitability on loans often increases if the spread between what is paid on deposits and what is generated on loans widens. But institutions accustomed to years of the Fed’s dovish monetary policy had to readjust and manage risk when the central bank doubled down on tightening. That created complications for many, chief among them SVB. A sharp rise in rates also hurts investment banking, particularly at a big bank like Morgan Stanley. The Wall Street giant previously benefited from structuring initial public offerings for companies, along with laying the groundwork for mergers and acquisitions. But with borrowing costs higher for corporate clients, banks have seen investment-banking profits decline. At the same time, banks are facing scrutiny from U.S. rating agencies. Moody’s downgraded 10 small and mid-sized U.S. banks on August 7, while Bank of New York Mellon (BK) and State Street (STT) were put on watch. “U.S. banks continue to contend with interest rate and asset-liability management (ALM) risks with implications for liquidity and capital,” Moody’s said. S & P Global followed suit on Monday, citing challenging operating conditions for the regional banking sector, sending shares of many big banks tumbling. Amid all these challenges, U.S. regulators in late July proposed strengthening capital requirements for the country’s largest banks — a development that could eat into banks’ revenue streams if they’re forced to lend less in order to hold more capital. Still, big banks will ultimately be able to manage any new regulatory hurdles, Oppenheimer’s Chris Kotowski told CNBC. “Banks will adapt to capitals over time,” he said. Oppenheimer on Friday slashed its price targets for a slew of big banks, including Morgan Stanley, arguing that the group has yet to fully recover since the closure of SVB. Bottom line Broadly, there’s too much uncertainty right now for the Club to invest further in bank stocks. It’s very difficult to fairly value financial names and determine the ultimate return on average tangible common shareholders’ equity, or ROTCE, if banks are forced to pull back on lending. Investors look to ROTCE as a key metric in assessing a bank’s earnings potential and valuation multiple. “How can you put a price-to-earnings ratio on something that we don’t know what they’re going to earn?” Jim said last week. What we do know is that Wells Fargo and Morgan Stanley both have strong capital positions with excess cash to return to shareholders, per the Fed’s stress test in June. With Morgan Stanley, there could be green shoots for investment banking. Jim has said there may be a pickup in mergers thanks to Big Tech, which could boost a long-dormant part of Morgan Stanley’s business. For Wells Fargo, the company is buying back the most stock of any of the big banks. And the firm continues to have a strong comeback narrative under the leadership of CEO Charles Scharf. “However, both Wells and Morgan Stanley can only be as strong as the weakest link. Without bank mergers [and] labor costs, there’s no way of knowing which banks they will be hostage to,” Jim said. (Jim Cramer’s Charitable Trust is long WFC, MS. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. 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A combination file photo shows Wells Fargo, Citibank, Morgan Stanley, JPMorgan Chase, Bank of America and Goldman Sachs.

Reuters

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