JPMorgan Chase & Co. and Goldman Sachs Group Inc. reported results Tuesday that easily breezed past consensus estimates. A closer look at valuation levels in the sector, however, suggests investors shouldn't get caught up in the optimism.
In my search for the bank valuation multiple with the best ability to predict future stock performance, the first discovery was that price to earnings ratios don't work. Comparing trailing and estimated price earnings ratios to the forward 12 month returns for the S&P 500 Bank Index (not pictured) shows no connection whatsoever.
Price to book value was far more successful. Forward price to book value, based on the average analyst projection on book value growth, was slightly better than trailing price to book value at predicting returns for the bank index.
The chart below compares price to estimated book value and the future 12 month returns for U.S. bank stocks. (The price to book value line is plotted inversely to better show the trend. A rising red line indicates a falling price to book value ratio.)
The price to estimated book value has frequently provided an early warning on bank stock performance. In the midst of the financial crisis, for instance, the price to book value ratio fell to 0.4, and this was followed by a doubling of the bank index in the next year. The falling price to book value in mid-2010 – from 1.1 to 0.8 – also successfully predicted a rally in the sector.
The trend suggests that U.S. bank stocks will be weak in the next 12 months before beginning a recovery. Investors looking to add U.S. bank stocks to their portfolio should wait for better valuation entry points.
Follow Scott Barlow on Twitter @SBarlow_ROB.