Attention: Australia’s big 4 banks are now fully priced

Could the widely held major banks be about to drop?

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It’s been a dream run for shareholders in Australia’s major banks. Since the depths of the global financial crisis, and in particular over the last two-and-a-half years, they have enjoyed incredible dividends and stellar capital gains. But that story might be nearing an end.

Until now, analysts have remained bullish on the stocks, believing that the lofty valuations given to some of the nation’s largest corporations were justified given the strong economic tailwinds guiding them. However, with Westpac Banking Corp (ASX: WBC), Commonwealth Bank of Australia (ASX: CBA) and Australia and New Zealand Banking Group (ASX: ANZ) all hovering around fresh all-time highs, three brokerage firms have changed their tune, indicating that they believe there is little upside potential from this point onwards. Here’s why:

Smaller yields

The yields on offer from the big four banks have declined as their share prices have risen. On average, the banks now offer a yield of 5.07% fully franked, with National Australia Bank Ltd’s (ASX: NAB) yield being the highest at 5.52% and Commonwealth Bank’s being the lowest at 4.79%.

Given the low interest rate environment, the yields on offer have been one of the primary factors behind the strong rallies of the big four banks. Bell Potter director Charlie Aitken argues that investors won’t bid down those yields any further by paying more for the shares. After all, there are plenty of other blue-chip companies offering more attractive dividends.

For instance, while their shares are more reasonably priced, Telstra Corporation Ltd (ASX: TLS) also offers a 5.52% fully franked yield, while Insurance Australia Group Limited’s (ASX: IAG) yield is sitting at an incredibly 6.2%!

Lofty valuations

The banks are expected to post a record combined profit for the year, topping last year’s $27.3 billion profit. Recognising this, investors have pushed shares in Westpac, Commonwealth Bank and ANZ to fresh all-time highs. Meanwhile, although NAB is still well below its record high of nearly $45 pre-GFC, it is sitting near a multi-year high at $35.16 a share.

At these prices, each of the banks are trading well above their 10-year average P/E ratios, indicating that investors believe they will be able to continue to grow profits at the rate they are today.

The problem is, that is unlikely to happen. One of the reasons behind their enormous profits has been low bad debts which are the result of the low interest rates. However, both of these rates will inevitably increase (perhaps sooner rather than later) which will put pressure on earnings and send shares downwards. John Abernethy, chief investment officer at Clime Asset Management, recently said: “People’s capacity to service interest and pay back debt can change dramatically if interest rates go up, even slightly.”  This will be exacerbated by the banks’ overexposure to the housing sector.

Foolish takeaway

It’s been a great run for shareholders in the big four banks and although they could climb further in the short-term, they are unlikely to prove to be solid medium-to-long-term investments.

Motley Fool contributor Ryan Newman does not own shares in any of the companies mentioned.

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