This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.

Bank stocks have come alive in May. As of April 30, large-cap bank holdings were lagging the broad market over the trailing 12 months, with the BKX (KBW Bank Index) posting a return of 9.88%, compared with 12.97% for the S&P 500 Index.1 However, between April 30 and May 19, the BKX had outperformed the S&P 500 Index by 2.32% (4.52% to 2.20%).1 This recent rally has put banks on the radar screen – and the combination of technical and fundamental factors suggests the momentum may just be starting.

Bank shares look to be breaking out

The BKX closed at a new 52-week high on May 19 and rallied above its approximate one-year trading range.1 In our view, this price action looks like the start of a positive trend and a continuation of the rally that had been in place from about September 2011 to March 2014. The chart below displays the technical setup for the BKX. Notice the upward-sloping channel from 2009’s low and the budding rally above the consolidation. Technical analysis can be more of an art than a science, but it is not uncommon for markets to consolidate before starting a new trend higher.

Banks are attractively valued

There are three valuation metrics that make the bank sector attractive:

  1. Banks are trading at a discount to the broad market based on book value. The BKX is trading at a price-to-tangible-book value of 1.58, compared with 6.33 for the S&P 500 Index. Furthermore, the BKX is trading at a price-to-tangible-book ratio below the January 2002 to April 2015 average of 2.23.1
  2. Banks have a low price-to-earnings (P/E) ratio. The BKX has an estimated P/E ratio of 13.59, which is lower than the S&P 500 Index’s estimated P/E ratio of 18.00. P/E ratios can be volatile, but this difference of 4.41 is less than the 3.03 median seen between January 2002 and April 2015.1
  3. Although the dividend yield on the BKX is slightly less than the dividend yield on the S&P 500 Index, the payout ratio is much lower at 26.7%. In my view, banks not only have room to return capital to shareholders as profits improve, but also appear to have the capacity to raise dividends.1

Valuation Measures

Price to Tangible BookEstimated P/E RatioDividend YieldDividend Payout Ratio
BKX1.5813.591.85%26.7%
S&P 5006.3318.001.99%46.0%

Source: Bloomberg, L.P. as of May 19, 2015. Past performance is not a guarantee of future results. Investments cannot be made directly into an index. Index performance is not meant to represent any funds performance. Common stocks do not assure dividend payments. Dividends are paid only when declared by an issuer’s board of directors and the amount of any dividend may vary over time.

Bank stocks have performed well when interest rates rise2

Bank stocks often display a positive correlation to interest rates, and the Taylor Rule suggests that the fed funds rate is more than 200 basis points (2.00%) below its equilibrium rate, using a real fed funds rate of 2.00%, an inflation target of 2.00% and a target unemployment rate of 5.00%.1 This indicates that interest rates should move higher, and an increase in rates is expected to improve bank net interest margins.

In addition to the chance for a favorable impact on bank profitability from tighter monetary policy, the BKX has tended to show positive relative performance to the S&P 500 Index during periods of rising interest rates.3 The table following displays the correlation of bank shares’ relative performance on a two-, five- and 10-year basis, compared with the two-year, five-year and 10-year Treasury yields. Higher interest rates are usually consistent with economic growth, strong demand for credit and rising bank profitability. Bank stocks may be a way to invest for improved economic growth after the potential winter slowdown.

Total Return Correlation: KBW Bank Index Relative to S&P 500 Index Compared to Treasury Coupons

As of April 30, 2015

   KBW Bank Total Return Index/S&P 500 Total Return Index to 10-Year TreasuryKBW Bank Total Return Index/S&P 500 Total Return Index to 5-Year TreasuryKBW Bank Total Return Index/S&P 500 Total Return Index to 2-Year Treasury
10 Year0.8900.9470.967
5 Year0.7550.6880.676

Source: Invesco PowerShares as of 4/30/2015. Past performance is not a guarantee of future results. Investments cannot be made directly into an index. Index performance is not meant to represent any funds performance. Common stocks do not assure dividend payments. Dividends are paid only when declared by an issuer’s board of directors and the amount of any dividend may vary over time.

Banks may offer investors the combination of a momentum and value play. A continuation of the budding technical breakout could signal the start of a new trend toward higher prices and could generate sector momentum, while the price-to-tangible-book value and P/E ratios suggest the sector is inexpensive.

After consulting with an advisor, investors looking for an opportunity to invest in bank shares should consider the PowerShares KBW Bank Portfolio (KBWB).

1 Source: Bloomberg, L.P., May 19, 2015

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