Be Cautious While Taking A Position In Bank Of America Stock

  • If long term rates don't rise, Bank Of America's earnings will not rise meaningfully.
  • Forward earnings are still quite high considering we do not know how the economy will respond to rising interest rates.
  • Corporate debt has doubled in the US over the last 7 years. If US dollar strength continues, this combined with rising interest rates will result in jobs being lost at US multi-nationals.

Will the Fed raise rates or will it not? That's the question facing Bank of America (NYSE:BAC) investors this week as many think a lift-off in rates would be bullish for the stock. On the whole I agree, as this bank's deposit numbers alone should mean that it can loan out at more favorable rates in the future but things are not as cut and dry as many think.

Firstly if you look at the Bank Of America stock's performance at different intervals in recent times, you will note that the stock rose sharply when economic numbers in the US were good and when the company reported a beat in its quarterly earnings,  which it has done in three of the last four quarters. In terms of earnings, I feel that the guidance  was too low which resulted in earnings numbers coming in better than expected.

Furthermore in terms of expectation of the Fed raising interest rates this week, just look at the recent price action of the stock which shows a 7%+ gain since the start of October (see chart). Economic numbers have been robust in the US recently especially the job reports which show that job gains have averaged 218,000 per month for the last three months (well ahead of expectations).

BAC stock chart

Source:Bank Of America Stock Price Data by amigobulls.com

Nevertheless we have seen that sentiment regarding the Fed moving on rates can change very quickly (as happened in mid-year) and when it does, Bank Of America stock falls more than other stocks in this sector. This is why the recent run-up the stock has had (due to a seemingly hawkish stance taken by the Fed) should alert investors that an imminent rate hike could be already priced into the stock, which will undoubtedly move the top line. But will a series of hikes move the stock past $20 a share which a lot of investors are predicting? I'm not so sure and here is why.

Depressed Long Term Rates

Firstly what banks need primarily is for rising earnings is higher long term interest rates - not short term interest rates which the Fed controls. Why? Well with billions current on deposit in the US (primarily due to investor fear since the great recession of 2008), banks want to be able to loan out this money at rising long term interest rates. Banks will have to pay interest to deposit holders ( normally associated with short term rates) and if this is lower than the long term rates it can charge on its loans, net interest margin should increase and the bank will make money.

However just look at long term rates at the moment in the US. Presently we are at 2.16% which is lower than both last month's 2.2% and this time last year's 2.21%. This trend is confirmed by the yield on the US 10 year bond which currently is at 2.12% but has been dropping since December 2013 when it topped out at just under 3%. What's the takeaway here on interest rates? Bank Of America needs long term rates to rise faster than short term rates. If the opposite happens (which is a probability in the near term), BoA's net interest margin will decrease which will hurt earnings.

Timid Retail Sales

Secondly a lot of investors are bullish on BoA stock due to its perceived attractive valuation. Currently its forward p/e ratio is 10.56 and its book value per share is around $22 which means it is trading at a 20%+ discount to its book value. The company returned $1.3 billion to shareholders last quarter which was a combination of its $0.05 quarterly dividend and share buybacks.

Furthermore with the Fed approving BoA's resubmitted stress tests, many shareholders now feel that the path is clear for the bank to start increasing its buyback's on mass in 2016 which should move the share price past $20 a share. Again there are too many unknowns for me to consider going all in here.

First we do not know know how the market will respond to a series of rising rates. Secondly retail sales are soft and really are only staying elevated as a result of buoyant auto-sales which again are coming from cheap credit and cheap oil. Thirdly the bank's forward earnings projection of 10.56 is not cheap when you compare it to its historic average which makes me believe that the present uncertainty in the market will refrain this bank from reducing its float meaningfully (which it increased substantially in the great recession) any time soon.

Rising Corporate Debt

Finally (and this is going under the radar as economists and analysts seem to really only concentrate on mainstream economic numbers) is the level of corporate debt in the US which incidentally has doubled since 2008. Couple the new freshly printed debt with the current strong dollar and you are dealing with a situation where earnings will need to keep up with higher corporate debt payments for people to stay in jobs (see chart).

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We have already seen in recent earnings numbers from US multinationals that the strong dollar is affecting top line growth meaningfully despite growth in product volume. This is what BAC bulls are missing. Even if BAC is not lending directly to customers or business with high debt loads, it is still lending indirectly. The whole economy is connected which is why over time I believe it wont be able to withstand a series of interest rate hikes which is bearish for Bank Of America.

Takeaway

So to sum up, I would be cautious about entering into a BoA position at this juncture. Recent Bank of America stock price action illustrates that an interest rate hike seems to be priced in but this doesn't necessarily mean earnings growth for the bank. Investors need to consider charge offs and loan growth in the event on interest rates increasing. There are still too many unknowns at this point as to what the bank's earnings will be in 2016. There will be plenty of time to go long this stock.

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Author's Disclosures & Disclaimers:
  • I do not hold any positions in the stocks mentioned in this post and don't intend to initiate a position in the next 72 hours
  • I am not an investment advisor, and my opinion should not be treated as investment advice.
  • I am not being compensated for this post (except possibly by Amigobulls).
  • I do not have any business relationship with the companies mentioned in this post.
Amigobulls Disclosures & Disclaimers:

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