The Hidden Logic of Bank Stock Prices
Bove, Richard X., American Banker
The Hidden Logic of Bank Stock Prices
To the casual observer, the movement of bank stock prices seems unfathomable. For example:
* Bond and stock prices do better when the economy is in the doldrums than when it is very strong.
* The securities markets usually do very poorly in October and November and very well in January and February.
* Stocks of banks and industrial companies seem to follow different rules. The price-earnings multiple of an industrial can be closely tied to the company's return on equity, which is clearly not the case with bank stocks.
Despite these seeming anomalies, the markets for securities and for bank stocks follow a well-defined logic.
Managements that understand this logic can build in higher prices for their stocks.
In this article I will discuss some macroeconomic considerations. In a future Comment, I will address issues specifically relevant to the stock of banking companies.
A Natural Flow
The prices of financial assets are driven by expectations of relative real returns.
To command a higher price, an investment must offer a better payback than other financial assets of similar risk. Also, there must be an expectation that the relatively high real returns will continue for a sustained period.
At any given moment, it is very difficult for investors to assess these factors. That is why the securities markets are volatile and uncertain.
If a management can convince investors that its stock offers sustained, high, real returns, the stock price will soar.
Competition for Funds
Why is the stock market generally lackluster when the economy is strong and vice versa?
At any point in time, the amount of money in the system is limited. The financial sector and the rest of the economy compete for that money. In general, both cannot have it at the same time.
For example, in the 1970s the stock market rose by 2.5% a year as measured by the Standard & Poor's 500. (Indeed, by some measures there was zero growth in stock prices from 1967 to 1980.) Yet during the 1970s, corporate earnings as measured by S&P showed the fastest growth on record -- 10.5% annually.
Conversely, in the 1980s the S&P 500 soared by an unusual 11.4% per year, while earnings were growing only by an inflation-equivalent rate of 4.1% annually.
The explosion in stock prices occurred in the middle of the decade, when corporate earnings showed no growth. Upward movement in prices faltered only when corporate earnings started to grow once again.
Ebb and Flow
Basically, money was flowing from one to sector to the other according to which offered the highest return.
When the return on economic activity was good -- that is, when the economy was strong -- money flowed out of the financial sector into inventories, receivables, and capital expenditures, driving up interest rates and depressing securities prices.
When the economy was weak and the returns on inventories, receivables, and capital expenditures faltered, the flow was reversed (after working-capital shortfalls were paid for) and funds returned to the financial markets. Interest rates declined and security prices soared.
One might argue that the stock market led the economy up or down because the market felt the impact of excess or depleted financial flows first.
Consider what happens at General Motors Corp. through an economic cycle:
* When the demand for automobiles increases, the company's treasurer begins redeeming short-term investments to buy steel and build cars. As demand continues to grow, the company may actually borrow in the open market and expand manufacturing facilities. The company goes from being a net provider of funds to being a net user.
* As the economy begins to slow, perhaps because the cost of funds has now risen to so high that consumers have trouble financing the purchase of new automobiles, the GM treasurer reverses course. …