Despite Bad News, Bank of America Stock Still Is a Buy

Stocks to buy

I’ve been a bull on Bank of America (NYSE:BAC) stock for some time now. But lately I’ve been feeling somewhat alone in that optimism. Bank of America stock touched an 11-month low in late October. A rally since then has been undercut, with BAC falling over 5% on Tuesday alone.

The sell-off admittedly makes some sense. On-again, off-again, cyclical and trade war worries have led to volatility in U.S. equities for most of the year and put pressure on big bank stocks.

Bank of America stock now is down 8%+ for the year. JPMorgan Chase (NYSE:JPM) has held flat, but Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C) are down 15% and 16% respectively, in 2018.

And of late, the pressures seem to be building. News for banks, and for BAC stock, generally has been negative the last few sessions. But for the most part, that bad news is priced in. And there’s still nice upside awaiting investors willing to ride out likely near-term volatility.

Flattening Yield Curve Is Bad News for Bank Stocks

The biggest driver of Tuesday’s decline seems to be a flattening yield curve. An inverted curve is a historical indicator of recession.  That aside, it causes significant problems for U.S. banks.

The business model of banking is to lend long-term and borrow short-term. The yield curve itself represents the difference between long-term interest rates paid to banks and the short-term rates paid by banks to depositors. If that gap moves toward zero, it hits bank profit margins and lending profits.

That gap has been meager for some time, owing in part to the zero interest rates that held for years coming out of the financial crisis. The rally in Bank of America stock coming out of the election came in large part due to hopes for higher interest rates and higher margins. Corporate tax cuts and hopes for lower regulation contributed to the optimism as well.

With the yield curve flattening, old concerns have returned. BofA will either have to make less money or take on more risk. Given that management has made a clear, concerted effort to avoid risk, as I wrote last month, that suggests flat earnings at best. And with a flattening yield curve often preceding recessions, cyclical risks seem more worrisome as well.

More Problems

The yield curve isn’t the only near-term issue. The Democratic Party will take control of the House of Representatives in January. Its leaders already have signaled that regulatory rollbacks will end.

Last month, James Brumley highlighted worries about pay changes at the Merrill Lynch unit. The company reportedly has been questioned as part of investigation into illicit money movements at Danske Bank (OTCMKTS:DNKEY). With Deutsche Bank (NYSE:DB) stock sliding amid money laundering investigations, investors probably have little patience for any type of government activity.

Meanwhile, federal data shows that credit card delinquencies are starting to pick up. Combined with the yield curve and other macro questions, it’s probably not surprising that Bank of America stock is being sold off at the moment.

Bank of America Stock Still Is a Buy

All that said, BAC stock trades at $27. The price to book value is just 1.13x. Bank of America stock trades at less than 10x 2019 EPS estimates.

There’s room in those valuations for risks to rise or growth to slow. The price to book value suggests little value for the franchise, or incorporates potential writedowns to the value of BofA’s assets. Earnings multiples suggest current profits are closer to a top than a bottom.

Even if many of the near-term risks come true, and growth comes to a halt, BAC stock may not have that much more in the way of downside. Zero earnings growth next year and a 10x multiple only suggests the Bank of America stock price comes down about 5%.

And if sentiment turns, there’s a clear path toward upside. 2019 EPS likely is just shy of $3 per share. A 12x multiple gets the stock to $34-$35 – above 2017 highs. (Worth noting: the average analyst target price is just above $34.)

To be sure, there’s some risk of a major recession and that might not be priced in. But that’s a risk that investors are taking in pretty much all U.S. equities. And with BofA clearly de-risking its business over the past few years, BAC could be best-positioned to weather a downturn and come out stronger on the other side.

It’s not a perfect story or one without risk. It was only a decade ago that bank stocks looked like they might be wiped out completely. But the pullback in BAC stock leaves most of the risks here priced in. And it seems to ignore a scenario where the news isn’t as bad as investors think it is right now.

As of this writing, Vince Martin has no positions in any securities mentioned.

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