Be wary of this bank stock rally

Bank shares on the London stock market are rallying. If you’re searching for potential bargains in beaten-down sectors I reckon the London-listed banks must have crossed your radar at some point over the last few years.

Is 2017 finally the year that the good value we think we see in stocks such as Lloyds  (LSE: LLOY), Royal Bank of Scotland (LSE: RBS) and Barclays (LSE: BARC) will ‘out’ to drive these firms’ share prices substantially higher?

Going up, but…

Since October, Lloyds’ share price is up 20%, RBS is up 30% and Barclays has put on around 34%. Yet forward prospects differ for these firms, which makes me suspect the current rally is driven by investor sentiment and speculation rather than sound underlying fundamentals.

For what it’s worth, which isn’t much, City analysts expect Barclay’s to increase its earnings per share by 51% during 2017, RBS by 30% and they expect Lloyds to post a 4% decline in earnings next year.

Yet earnings have been volatile in recent years. If you look at trading results for the last five years and projections for the next two years, you’ll see big declines in yearly earnings per share as often as you see rises.

The share chart tells the story for longer-term investors: Lloyds is down around 23% since early 2014, RBS is down 41% and Barclays down 25%. Big cyclical beasts like the major London-listed banks don’t make decent buy-and-forget investments, especially now after a long period of relatively large profits.

The third way

As investors, we all seem drawn to search for bargains in sectors beaten down by bad news, setbacks and poor investor sentiment. What better place to look than the banking sector then? After all, it has been beaten and thrashed by regulators, scandals and economic circumstances for years.

Valuations look attractive at first glance. Lloyds trades on a price-to-book value around 0.96, RBS is 0.49 and Barclays is around 0.6. So, are we seeing the banking industry poised to recover and shoot the lights out during 2017, or is an investment now a high-risk proposition with potential to plunge?

I reckon neither  option is likely in the medium term. Maybe the big banks will take a third way and remain bogged down delivering a flat total return for investors over the coming years. That has certainly been the case since around the end of 2013 and I see no reason why the situation shouldn’t continue. We don’t know what regulatory requirements will hit the banks in the future, or how much fines will escalate for their misdemeanours, how competition will erode their trading position in the UK, or how many more high-risk but previously profitable operational strategies they will abandon.

Wading through porridge

Cyclicality means bank stocks will likely perform as if they’re wading through porridge from here anyway, even without all the firms’ other challenges being taken into account.

I reckon the market will keep nibbling away at the banks’ valuations as the wider macroeconomic cycle matures in an attempt to discount for the next cyclical down-leg, which will see profits and share prices plummet. So that’s why I’m wary of the banks now. I wouldn’t want to be holding their shares when the music stops again.

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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has recommended Barclays. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.