China Securities Co., Ltd.: Is the historical attribution of the American banking sector driven by valuation or fundamentals?

Core viewpoints: The stock price changes of U.S. banks are primarily driven by valuation rather than performance, meaning that the direct elasticity of stock price to valuation is much greater than to fundamentals. Valuation determines whether the price rises or not and absolute returns. Further, beneath the surface of valuation, the U.S. market prices banks' fundamentals extremely fully. Which banks improve valuation, which ones kill valuation, which ones rise more, and which ones fall more are closely related to the trends of each bank's fundamentals. Fundamentals determine how much a stock rises and relative returns. Additionally, the impact of valuation and fundamentals differs significantly at different stages. Investors need to closely track fundamentals in all stages and accurately differentiate between different stock price cycles, grasping important stage factors such as valuation and market value outside of fundamentals. Full report: We decompose the stock price increases of the U.S. bank sector into valuation factors and fundamental factors, and classify four typical stages based on the different combinations of these two factors. The stock price performance in these four stages ranges from high to low: valuation and fundamental both rising stage>valuation rising, fundamental not improving stage>fundamental improving, valuation not rising stage>valuation and fundamental both falling stage. Valuation determines whether the stock rises or not, fundamentals determine how much it rises: the stock price performance of the U.S. bank sector and individual stocks is more influenced by valuation changes, but the U.S. market prices the fundamentals extremely fully. In the four different historical periods, it consistently determines the relative performance of stocks within the sector. Moreover, low valuation is an important source of excess returns for individual stocks, and market value factors have a significant impact in extreme stages. Stage 1: Valuation and fundamental both falling within the sector: a time of crisis where stability is crucial, similar to moments of systemic risks such as the subprime crisis and global pandemics. Within the sector, banks with more stable fundamentals have smaller declines in stock prices, banks with similar fundamentals but lower valuations have smaller declines, and banks with both similar fundamentals and valuations but larger market values have smaller declines. Stage 2: Valuation and fundamental both rising: a period of improvement after a crisis, which generally occurs during a post-crisis restoration period. Within the sector, banks with significant positive improvements in fundamentals and lower valuations experience larger increases in stock prices, but smaller banks perform better if either fundamentals or valuations are preferred. It is evident that regardless of whether it is a time of panic during the crisis or optimism after the crisis, the market's pricing of fundamentals is comprehensive, and the preference for valuation advantages is clear, but the choice of market value (i.e., stock price elasticity) is opposite. Stage 3: Fundamentals improving, valuation not rising: stocks that can improve valuation rise more, but fundamentals are an important determining factor for whether valuation can improve, often occurring during times when supportive policies are in force and there are still disagreements in market expectations about the economy. In this stage, while fundamentals are generally improving, valuations within the sector are not increasing overall, therefore within the sector, individual stocks that improve valuation are more important, with an increase in valuation being greater than an increase in performance, leading to significant additional returns for stocks that can improve valuation, with market value factors having less significant impact. Stage 4: Valuation rising, fundamental not improving: fundamentals are key to stocks' excess returns, which usually occur when economic expectations are clear but monetary policy and the business environment are not moving in a direction that is favorable for banks. During this stage of overall sector valuation improvement, the strength of fundamentals is the primary factor for stock price excess returns, with low valuation being the secondary factor, and market value factors having little influence. A strong fundamental trend can offset the adverse effects of high valuation, and a reversal in fundamental trends is a key reason for stock price weakness. Stocks with bottom reversals, i.e., those that can achieve the optimal combination of "good fundamentals + low valuation" are the best performers in this stage. Looking ahead, the most likely scenarios are stages 3 and 4: we predict that the U.S. banking sector is currently in stage 4, based on positive economic expectations and relatively positive performance indicators for banks, with stages 1 and 2 being less likely. With support from neutral policy rates and an inclination towards loose regulation in the future, the U.S. banking sector is expected to maintain stable performance at the current high levels. Whether the sector remains in stage 4 or transitions to stage 3 will largely depend on valuation, which in turn will be influenced by expectations for the overall U.S. economy and market. The focus on both offense and defense is crucial in stock selection: historical attribution shows that in stages 3 and 4, large U.S. banks tend to perform exceptionally well. Combining current performance indicators and valuation levels, we expect that large banks are the preferred choice for investors at this stage, especially those in the lower valuation percentiles historically. Apart from large banks, banks that continue to improve Return on Tangible Equity (ROTE) are also a favorable choice. Attribution of U.S. bank stock performance: valuation determines whether the stock rises, fundamentals determine how much it rises Historical attribution of the U.S. banking sector: valuation determines whether the stock rises, fundamentals determine how much it rises We decompose the stock price increases of the U.S. banking sector into valuation factors and fundamental factors, and classify four typical stages based on the different combinations of these two factors. Conclusion 1: The stock price performance in these four stages ranges from high to low: valuation and fundamental both rising stage>valuation rising, fundamental not improving stage>fundamental improving, valuation not rising stage>valuation and fundamental both falling stage. Conclusion 2: The stock price performance of the U.S. banking sector and individual stocks is more influenced by valuation changes, but the U.S. market prices the fundamentals extremely fully. In the four different historical periods, it consistently determines the relative performance of stocks within the sector. Additionally, low valuation is an important source of excess returns, and market value factors have a significant impact in extreme stages. We summarize valuation factors and fundamental factors using Price-to-Book (PB) and Return on Tangible Equity (ROTE) and further break down the core fundamental impact factors at different stages based on ROTE. Attribution of stock price changes and individual stock analysis in different stages of a cycle Stage 1 - Valuation and fundamental both falling: 2006-2009, subprime crisis Stage 2 - Valuation and fundamental both rising: 2009-2010, post subprime crisis recovery Stage 3 - Fundamental improving, valuation not rising: 2010-2012, stabilization of economic trends Stage 4 - Valuation rising, fundamental not improving: 2012-2017, valuation follows improved economic expectations Which stage is the U.S. banking sector currently in? Which stage will it enter in the future? Which types of banks are best positioned for offense and defense? Currently, the U.S. banking sector is in a relatively good stage of valuation rising and fundamentals stabilizing (stage 4). Based on positive economic expectations and relatively positive performance indicators for banks, the probability of entering a stage of valuation and fundamental both falling (stage 1) is low. The optimal stages of valuation and fundamental both rising often occur after a systemic risk event, which is also currently unlikely (stage 2). With support from a higher neutral policy rate, the U.S. banking sector is expected to maintain stable performance at the current high levels. Whether the sector remains in stage 4 or transitions to stage 3 (i.e., good fundamentals but no rise in valuation) will depend largely on valuation, which in turn will be influenced by expectations for the overall U.S. economy and market. Historical attribution shows that in stages 3 and 4, large U.S. banks tend to perform exceptionally well. Combining current performance indicators and valuation levels, we expect that large banks are the preferred choice for investors at this stage, especially those in the lower valuation percentiles historically. Large banks aside, banks that continue to improve Return on Tangible Equity (ROTE) are also a favorable choice. Risk Notes 1) The policies implemented by the Trump administration are ineffective, leading to a more severe economic recession in the U.S. in the near future than what the market currently expects. 2) The Federal Reserve increases the intensity of lowering interest rates, pushing the policy terminal rate below 3%, or even lower. In extreme cases, a return to a zero interest rate environment globally could have a significant negative impact on banks' net interest margins and operational abilities. 3) Unforeseen global geopolitical tensions and risks arise, affecting the U.S. economy and political environment, leading to the emergence of gray rhino events. 4) Regulatory requirements for the core Tier 1 capital adequacy of banks become more stringent, impacting the fundamental operating conditions of banks. 5) All of the above risks could have adverse effects on banks' asset quality and capital positions.