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3 things you should know before buying or selling ASX bank stocks

You may want to channel Charles Dickens if you are struggling to decide whether to buy or sell ASX banks shares as this is the best of times and the worst of times for our bank stocks.

There are few other large cap stocks that illicit such conflicting views from investors as arguments of overvaluation is offset by the frantic hunt for yield.

It’s hard not to be drawn to the big four ASX banks, which are offering up yields between 7.6% and 9.6% if you include franking credits. That’s attractive compared to other asset classes.

On the flipside, detractors point to the tough earnings growth environment and the fully valued share prices as reasons to avoid the sector. This won’t help conflicted investors, but both groups are right!

To help sort your thoughts on this question, here are three key things I think investors should ponder before making a decision.

Growth or yield

Flat is the new up when it comes to bank stocks, in my opinion. The key question isn’t whether banks can grow earnings but whether they can sustain their dividend payments.

Banks don’t need to deliver earnings growth to stay in investors’ good books – not when the outlook for interest rates is “lower for longer”.

The Commonwealth Bank of Australia (ASX: CBA) offers the lowest yield of 7.6% (including franking) and even that’s very attractive. In contrast, the Australia and New Zealand Banking Group (ASX: ANZ) share price is on a yield of 8.4%, National Australia Bank Ltd. (ASX: NAB) share price is on 8.7% and Westpac Banking Corp (ASX: WBC) share price is on a whopping 9.6%.

I believe the varying yields reflect dividend risk. CBA and ANZ Bank have the lowest risk to their dividends, while Westpac looks like it’s cum-dividend cut to me.

Goldilocks and house prices

The market has been getting excited by headlines declaring that the housing market recovery is afoot. This view has help bolster the sector.

It could be a case of being careful for what you wish for. Falling home prices are bad news for banks as it pushes demand for mortgages off a cliff and opens the risk of more borrowers being in negative equity.

But if prices rebound strongly, it won’t be good news for banks either given the amount of debt held by households, which will introduce systemic risks for banks over the medium to longer-term.

The best outcome for the sector is for house prices to stabilise. This will give confidence to homebuyers to enter the market and to ensure that they won’t get priced out like they were in the previous hot market.

It’s a Goldilocks scenario. Not too hot, not too cold, but just right.

The RBA’s double-edged sword

The Reserve Bank of Australia’s (RBA) move to cut interest rates to new a record low is seen as a positive for the housing market but it isn’t necessarily good news for the banks.

While lower borrowing costs will stimulate demand for loans and help the banks’ top-line, it squeezes bank margins and that hurts their bottom-line.

Banks have been protecting their margins by lowering rates on savings and term deposits faster than lending rates but there’s a limit to how much more they can cut given that savers would struggle to find rates better than 2%.

While theoretically banks still have another 200 basis points they can draw on to buffer margins, I don’t think they can lower this much more without losing depositors. If savings rates go any lower, many will likely be forced to pull out their cash and invest in riskier assets to make an acceptable return.

Ironically, I suspect a good chunk of this could end up being used to buy bank stocks.  

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Motley Fool contributor Brendon Lau owns shares of Australia & New Zealand Banking Group Limited, Commonwealth Bank of Australia, and Westpac Banking. Connect with him on Twitter @brenlau.

The Motley Fool Australia owns shares of National Australia Bank Limited. 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 Scott Phillips.

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