Anthony Speciale Stock Market Analyst

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Why the Current Market is Perfect for these Two Bank Stocks

One of the topics that’s at the top of everyone’s conversations when it comes to financial markets and the world we live is inflation and what exactly inflation is going to do to long-term and short-term interest rates.

There has been a lot of discussion, and while every pundit seems to have a different view of how it will play out, we don’t have to have this big, massive debate… We just have to learn how to listen to what the financial markets are telling us. The markets have laid out very clearly what is going to happen with inflation and interest rates, so let’s take a look at what’s happening the real world.

When I look at short-term interest rates, what’s clearly happening is that rates are rising, and they have been rising ever since we started to see inflation pop up in the regular numbers that have been coming in. Inflation is running really hot right now, and when you look at energy and food, it’s even higher. We are going to have inflationary pressures, and it’s pretty much inescapable.

There is a severe natural gas and oil shortage that’s not going away anytime soon. That’s going to be with us for a while. The energy situation in particular is troubling because there are the ridiculous ESG investment policies being adopted by pension funds all across the United States, so it’s actually a disincentive for oil companies to go out and produce more oil.

Now, the only way to bring down the price of a commodity is to increase the supply… But we’re not doing that, and there are no plans to do that. Everything is incentivized towards renewable energy right now. So, we are not going to get that much of a break in energy prices anytime soon. Supply and demand are way out of balance.

Then, when you look at what’s going on in the food market, that’s also going to be with us for a while. Food inflation is also supply chain driven, and that will in fact go away, but maybe not as quickly as some might hope.

It’s going to be the same thing for the semiconductor shortage, which is causing some price inflation in just about everything, as it’s pretty hard to name a product these days that doesn’t have a semiconductor chip in it.

The point I’m trying to make is that inflation is going to be with us for a while, and the Federal Reserve is going to try to fight it by raising interest rates as soon as the second half of 2023. The markets are naturally going to raise rates by themselves in response to inflation, and we’re already seeing that in some of the shorter-term debt markets.

Now, let’s take a look at the rest of the picture… Long-term bond rates like for 20-year and 30-year bonds are actually going down. These bonds are looking much further out and looking at the economic scenario several years from now. So, those rates are going down as they’re looking at a post-stimulus world in which we’re probably going to see growth rates go back to 2% a year or less.

Something really interesting happened just about a week ago, as we saw the yield on the 30-year bond go below the yield on a 20-year bond. That’s not supposed to happen, and it’s called a yield-curve inversion. And when this happens, we usually see a recession develop 24-28 months down the road.

So, the markets are speaking to us very plainly. We’re going to see short-term inflation. Rates are going to bump up. The Fed is going to do what the Fed does and overreact to inflationary pressures by raising interest rates. They’ll go too far, the economy will slow down and we’ll slip into something of a recession a couple years down the road. That is the most likely case right now. The bond market has spoken, and it’s usually dead-on in its predictions about the future of interest rates.

But how do we play this situation? Well, simply by owning bank stocks! This is the perfect environment for bank stocks. Yes, they’re boring, but they can make you a lot of money in an environment like this.

Now, rates going up in the short term means we will see net interest margins (NIMs) go higher, which will mean higher profits, higher earnings, higher dividends, more stock buybacks and all of things that happen that make bank stock begin to move higher in price.

We’re seeing everyday banks hitting new highs all across the board from small to large banks because they’re reacting very favorably to the prospect of higher interest rates over the next year or so. And if we do slip into a recession, that’s actually going to be wonderful for banks, as recessions create more merger and acquisition activity. That’s the only way for a bank to grow in a recession.

Sterling Bancorp, Inc.

But for now, I have two picks that should get you started on this road. First up is Sterling Bancorp, Inc. (SBT) out of Southfield, MI, which has about 29 branches and about $3 billion in total assets. This makes it a perfect target for another bank that is looking to be in the suburban Detroit market.

SBT is primarily a single-family home lender, with lots of extra capital and a very reasonable loan portfolio of about 80% in single-family homes in a fairly wealthy suburb of Detroit.

The stock is trading at about 92% of book value, or the net worth of the company, placing it at a bargain level relative to most other bank stocks.

It’s also pretty vulnerable, in my opinion, to a takeout for a bank that wants to be in the increasingly attractive Detroit banking market.

ESSA Bancorp, Inc.

Next up is ESSA Bancorp, Inc. (ESSA), which is out of Stroudsburg, PA. The company has been growing in two directions — up towards Allentown and Scranton via acquisitions and back down towards the Philadelphia market.

This is an extremely well-run bank and is one of the best in the business. They are paying and increasing the dividend. They are buying back stock. And they are making really smart acquisitions to grow the asset base and reduce costs.

The bank is trading at less than 10 times earnings and less than 90% of book value right now, and anyone that wants to be in that Philadelphia to Scranton market is going to look at this bank and see a strong takeover target.

Both of these banks should do very well under the scenario that the bond markets are telling us is going to happen with inflation and interest rates. We’re going to see a period of higher inflation, higher interest rates and a Fed overreaction that takes rates back down but tips the economy back into a recession.

That is perfect for small to medium-sized bank stocks.