Plenty of analysts are calling bank shares overvalued, and have sold into the recent rally. But that view doesn't stack up with the ongoing hunt for yield.

So are the banks overvalued and a sell or is it actually different this time? Many readers know my views on the ‘it’s different this time’ phrase and how it usually has me running in the exact opposite direction.

However, not in this situation. It is different this time because interest rates are at their lowest level in 50 years and returns on cash products aren’t too far behind them.

The bulk of the analyst community have been downgrading the banking sector to a sell on the premise that bank stocks have simply run too far and are now stretched on any number of valuation metrics.

Interestingly, the same thing happened back in November after the banks had surged 22 per cent from their June 2012 lows. They got this call relatively correct as the ensuing pullback post Obama’s re-election saw the banking sector sell off 5.8 per cent. Well, I say correct assuming they bought back into the weakness, because from there the sector took off once again, surging another 22 per cent to find itself up nearly 40 per cent since mid-2012. This can be seen in the chart below of the ASX banking sector.


You don’t have to look too far to realise that investors have been chasing yield in this period of low interest rates. Put simply, returns of around 3.5 per cent on cash deposits simply aren’t enough for people to live on.

The chart below proves that this is what has been happening.


Bear with me here. The purple line is the estimated yield 12 months ahead (left hand axis) for the banking index while the dashed white line is the actual banking index. The solid white line (far right axis) shows expected interest rate cuts in basis point terms over the next year.

So in mid-2012 you can see that the banks were expected to yield around 8 per cent while interest rates were expected to be cut by approximately 150 basis points over the next year. This basically marked the low in the banking sector as the yield differential on offer between banks and cash rates was at its maximum and hence firmly in favour of buying banks. 

From what I’m hearing on the street, it would be the exception rather than the rule to find institutions that had not sold their overweight bank positions into the most recent rally.

They are expecting and hoping that banks pull back at least 10-15 per cent.

So for the analyst community to be proven correct in this situation, retail money needs to sell banks that are yielding 6 per cent fully franked and move that money into cash, which is yielding 3.5 per cent in the best case scenario.

It’s just not going to happen, in my view. There is no way people are going to halve their investment income just because 1) banks have run too far, or 2) they look stretched from a valuation perspective.

There are too many buyers still looking to move into high yielding stocks and few willing to sell out. The numbers just don’t stack up yet.

    InvestSMART FORUM: Come and meet the team

    We're loading up the van and going on tour from April to June, with events on the NSW central & north coast, the QLD mid-north coast and in Perth, Adelaide, Melbourne, Sydney and Canberra. Come and meet the team and take home simple strategies that you can use to build an investment portfolio to weather any storm. Book your spot here.

    Want access to our latest research and new buy ideas?

    Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.

    Sign up for free

    Related Articles