Did the stress tests spell doom for small-cap bank stocks?

For much of this year, shares of small and mid-size banks outperformed those of bigger lenders. With the financial industry in turmoil and some of its largest players seemingly on the brink, investors flocked to regional and community banks that weren't as exposed to the fallout from risky bets on complex instruments like collateralized debt obligations and credit default swaps.

All that changed on April 9. That day, the KBW Bank Index, which tracks the stocks of 24 big financial institutions, including Bank of America (BAC), JPMorgan Chase (JPM), and Wells Fargo (WFC), zoomed past the KBW Regional Banking Index, which comprises 50 smaller banks ranging in size from Valley National Bancorp (VLY), with a market cap of $1.6 billion, to UCBH Holdings (UCBH), with just $158 million worth of shares trading.

Large-cap bank stocks haven't looked back since. Indeed, they're now outperforming the small-cap index by more than 18 percentage points on the year through Friday. So what happened?

Well, it was on April 9 that The New York Times reported that regulators planned to effectively bless the balance sheets of the 19 financial institutions undergoing their "stress tests." All of those companies were quite big, with assets of more than $100 billion.

As Times reporter Eric Dash wrote in the article, which appeared on the front page of the paper's business section, "This is a test that a bank simply will not fail."

That same day, Wells Fargo, the fourth-largest U.S. bank by assets, announced it had posted a record profit of $3 billion in the just-concluded first quarter. Its shares jumped 32 percent on the news. JPMorgan, Citi and Bank of America rose sharply as well.

Investors were clearly happy, but some analysts raised warning flags. ISI Group's Ed Najarian told The Wall Street Journal that he saw Wells's results as "unsustainable and designed to show regulators that [it] has strong underlying earnings power ahead of the bank stress tests."

Of course, it's impossible to say for sure whether the day's events caused the yawning chasm that has since opened between large-cap and small-cap bank stocks. But it does suggest that the stress tests sent investors a powerful signal: Big banks are safe again. In fact, even with their warts, they're now safer than smaller lenders.

"The stress tests really were an inflection point for the big banks," said Paul Larson, equity strategist at Morningstar. "The government made it clear that nationalization was off the table for all these companies."

The shift is a big deal for at least two reasons. First, investors in small-cap bank stocks may have lost out relative to shareholders of bigger financial firms. Second, the government's stress test may have only applied to giant banks, but that doesn't mean they're the only ones that may need more capital. Falling stock prices would make raising it more expensive.

Undoubtedly, there are reasons to suspect there's no cause-and-effect relationship at work here. Money manager David Ellison, whose funds, FBR Small Cap Financial and FBR Large Cap Financial, boast $183 million and $20 million in assets respectively, says big banks' outperformance follows from investors' enthusiasm for their fee-based businesses, like running mutual funds or processing payments, that smaller banks usually aren't involved in.

"If you've got the money management income to offset losses on loans, that will smooth out the earnings," said Ellison, who recently told The Wall Street Journal that he's moving his funds' assets out of cash and back into stocks. Income from investment banking could play the same role at companies like JPMorgan, Ellison said.

"The big banks have a lot more non-lending fee income that they can use to accelerate the getting-better process," he added. "So they will be the first to show a cleaner balance sheet, more stable book value, and they'll show much more progress on non-performing loans."

"I don't think it's any more complicated than that," he said.


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