Is now the right time to be buying ASX bank stocks?

There are a few important takeaways that can be gleamed from the breathtaking rally in ASX bank stocks on Wednesday. Here's what every ASX investor needs to know…

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The breathtaking rally in ASX bank stocks ensured that financials were the best performing sector on the S&P/ASX 200 Index (Index:^AXJO) on Wednesday.

Adding to the "wow factor" was volume. The big surge in big bank share prices was on the back of very high turnover.

The Australia and New Zealand Banking GrpLtd (ASX: ANZ) share price led the charge with an 8.6% rally to $17.94. Westpac Banking Corp (ASX: WBC) is close behind with an 8% rise to $17.61, while National Australia Bank Ltd. (ASX: NAB) gained 7.8% to $17.94.

The Commonwealth Bank of Australia (ASX: CBA) share price was last in line but shareholders are unlikely to complain about its 4.9% jump to $64.30.  

This buying frenzy suggests a couple of things about our market and where we might be heading.

Pent up demand for bank stocks

The first is that institutional investors who have been underweight banks may now be having a change of heart.

While it's hard to tell who was frantically buying bank stocks today, many professional investors had shunned the sector due to worries that a wave of loan defaults from the COVID-19 pandemic would bring the sector to its knees.

But a string of better than expected economic data and updates from numerous ASX stocks exposed to discretionary spending showed things might be springing back to life as coronavirus restrictions are eased across Australia.

This is further evidence that the worst of the coronavirus fallout is behind us and the big discount on ASX bank stocks are starting to unwind.

Bank dividends on the way back up

This is why three of the big banks are outperforming CBA. These stocks were trading at around a 20% discount to book value to reflect their lower quality balance sheet relative to CBA, while the outlier was trading at around 1.5 times book value.

What I also believe is that NAB will be the only bank raising capital during this downturn and that ANZ and Westpac will resume paying dividends at their next profit results.

CBA shareholders are the lucky ones. Our largest domestic bank has a different reporting cycle and didn't have to declare its profit and dividend during the height of the COVID-19 disaster.

This doesn't mean it won't lower its final dividend in August, but even if it does, I suspect it won't be as much as the market expects.

Rotation from defensive stocks

The final observation is that investors are using defensive shares to fund their purchases of bank stocks. This includes outperformers like healthcare leader CSL Limited (ASX: CSL) and gold producers like Evolution Mining Ltd (ASX: EVN).

This trend could continue, particularly for healthcare stocks, although I think it would be a mistake to go underweight on gold stocks in this environment.

Foolish takeaway

But this isn't to say the banks have a clear run ahead. There are questions about what happens when the government's JobKeeper payment ends and goodwill from loan repayments and rents run out.

There are also concerns about falling house prices as property investors desert the market and structural changes that can shake the foundations of office and retail properties.

However, I think these risks are manageable unless house prices fall by substantially more than 10%, we get a big second wave of COVID-19 infections, or both.

If you have no or limited exposure to the big banks, you should be adding these stocks to your portfolio.

Brendon Lau owns shares of Australia & New Zealand Banking Group Limited, Commonwealth Bank of Australia, Evolution Mining Limited, National Australia Bank Limited, and Westpac Banking. Connect with me on Twitter @brenlau.

The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of CSL Ltd. 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 Scott Phillips.

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