What’s going on with bank shares?

Credit: Kiwiteen123

Last week saw a very credible performance by major bank shares. While the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) gained 4.5%, all four major banks rallied even harder.

Here’s how the “Big 4” performed last week:

Westpac Banking Corp (ASX: WBC) rallied 8.3%

Australia and New Zealand Banking Group (ASX: ANZ) jumped 6.9%

National Australia Bank Ltd. (ASX: NAB) added 6.3%

Commonwealth Bank of Australia (ASX: CBA) climbed 6%

Given that all four banks have significantly underperformed the index over the past year, it’s perhaps not surprising that they should outperform during an upswing.

The question investors considering buying bank stocks need to ask themselves is where to next?

Cyclical headwinds abound

While the low interest rate environment is limiting the margin banks can earn there are bigger issues at play.

The regulator APRA is looking to strengthen the banking sector by forcing banks to hold more capital. This ultimately reduces the ability of a bank to leverage up its balance sheet.

The property market is on the nose. Even the Reserve Bank of Australia (RBA) is warning of a glut in inner city apartments. When coupled with the wider sky high property market this could all spell trouble ahead for the banking sector and their all-important mortgage businesses.

The only way for bad loans is up! Australian banks have been enjoying record low defaults and bad loans, which has been great for their bottom lines. This trend looks set to unwind as the cycle turns and the write-off of loan losses rises.

Buyer beware

A general market rally could see positive momentum for bank shares – although given their weighting it’s hard for the index to rally without the banks. Overall, investors need to be careful about buying into the current rally as the cyclical headwinds outlined above are likely to have a multi-year negative effect on bank earnings.

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Motley Fool contributor Tim McArthur has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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