2023-07-20 14:00:34 ET
Summary
- In my last USB article, I lowered my buy price to under $26 per share in preparation for a potential recession.
- USB stock nearly hit that price and has risen post-earnings.
- The risk of deposit flight and defaults are likely priced into the stock now, but a recession is not in my view.
- I remain cautious over the next 12 months.
Introduction
I always like to start my articles by reviewing any previous coverage I've had of a stock. My first U.S. Bancorp (USB) article was in 2020, soon after I purchased the stock on 5/13/20. I wrote about that purchase in my 7/15/20 article " Stocks I Bought On The Dip: U.S. Bancorp ". After holding the stock for about a year-and-a-half, I took profits on 12/20/21 and I wrote about that sale in the January 19th 2022 article " Why I Recently Took Profits in U.S. Bancorp ". Here were my returns compared to the S&P 500 index ( SPY ) over that time.
That investment worked out very well for me and produced a double in about a year and a half, handily outperforming the S&P 500. Since I sold USB here is how it has performed:
Overall, my strategy did a good job, both with the purchase and the sale of the stock. Over the past couple of years I've written two more articles on USB, in the first I shared my initial buy price for USB after the stock had started falling, and in my last article, in April of this year, I shared why I was lowering my potential purchase price of USB to $25.43 per share. After that article, USB's price bottomed at about $27.27 per share, so we got pretty close to my more conservative buy price, but it didn't quite hit.
In this article, I'm going to review USB to see if I think anything has significantly changed after the latest earnings report.
USB's Historical Earnings Cyclicality
I am a firm believer that history offers a good guide for the future. The thing I do when examining any stock is to look at its earnings history and what the historical earnings pattern looks like. In particular, I want to see a business with rising earnings over time, and I want to see how cyclical earnings have been. Rising earnings are a sign of business quality, and earnings cyclicality tells me what sort of valuation technique makes sense for the stock. If earnings are too volatile or cyclical, they can be a very unreliable measure of the business, especially during times of inflection around peaks and troughs. So, if I find a business has a history of earnings growth falling -50% or more, I usually don't use earnings to value the stock and instead use historical price patterns.
Examining USB's history we see that EPS growth fell far deeper than -50% in 2008/9. It also had a significant decline in 2020 and 2022. These years correspond very well with general economic activity, so I think it's fair to say that USB's business is economically sensitive and deeply cyclical. It's also worth noting, however, that USB's earnings have always recovered in a timely manner from these downcycles, and this makes it what I'll call a high-quality deep cyclical business. These are the types of deep cyclicals I prefer to invest in, as long as I can buy them at a good price. This is exactly what I was able to do in 2020.
Because earnings aren't the best way to value deep cyclical stocks, I use historical price cycles as a guide. So, below I have shared a table that contains USB's historical down cycles over the past 35 years.
Year | ~Time Until Bottom | ~Duration | ~Depth |
1989 | 15 months | 2 years | -45% |
1999 | 15 months | 5 years | -62% |
2008 | 6 months | 4 years | -76% |
2020 | 3 months | 1 year | -52% |
2023 | ? | ? | -52% (so far) |
The typical deep cyclical stock I buy with this strategy I purchase at about -50% off its highs. I aim for it to return to new highs within 5 years, and I make about a 100% return if all goes as planned. USB in 2020 was exactly that sort of typical stock. I bought it about -50% off its highs and it basically doubled, at which point I took profits. In my April article, I announced that I had decided to go with a lower buy price that corresponded to a -60% drawdown instead of -50% because I expected an economic recession that would be particularly hard on regional banks and the last two times that happened, in the 1999 downcycle and the 2008 downcycle, USB fell deeper than -60% both times.
This strategy is designed to try to get us in at roughly a good spot, but I don't claim to have a lot of precision. I monitor a wide variety of stocks, including banks, and usually if we get close to my buy prices at least some of the banks will hit. In the case of last spring, I only bought one bank, UMB Financial ( UMBF ), and I wrote an article about that one titled " Post Crash UMB Financial Stock Has A Good Risk/Reward ". It has been my only public "Buy" article in 2023, and though I have bought some other stocks in my Investing Group, The Cyclical Investor's Club, none have been banks. So, I think my valuation methods are working kind of how one would expect after a big initial drop in regional banks. A few banks with quality histories came close to reaching the levels I wanted, but only one hit so far.
After some weakness, UMBF has performed about the same as the S&P 500.
Current Considerations
I always try, when I can, to boil my investing thesis down to one or two points that might differentiate my view from that of the market. Right now, given what we know, I think the market is pricing the risk on regional banks about right. The biggest questions marks are 1) what sort of loan losses might they experience, and 2) what will keeping deposits cost them? But also we need to think about how long this situation will last and when earnings return to some normal level of growth going forward.
Unfortunately, nobody knows the answer to these questions, but one thing I do feel pretty confident about is that a recession is not priced into these banks, yet. It might seem like it given the price drops, but I think really what has been priced in is the cost of commercial real estate loan defaults and the deposit flight risk. The rebound we have seen this past quarter in stock prices I think can mostly be attributed to a more stable deposit situation. From the recent earnings report:
Average deposits slipped to $497.3B from $510.3B in the previous quarter.
I think that's about what would be expected when people are done panicking. So, the panic is over. The Fed also paused raising rates for a month, and disinflation was a little stronger than expected. Overall, this creates a more stable environment, and banks have more time to set aside more reserves for loan losses. That's all good, and I think the market mostly has all this priced in, which is why this past quarter has been decent for bank stocks post-crisis.
However, I do not believe that a recession is priced into USB or most other regional bank stocks. If a recession occurs, then defaults across the board will rise, and we should see stock declines roughly in-line with previous recessions, which for USB meant a stock price decline of -60% to -75% off its highs. We aren't quite there, yet, and the Fed hasn't even stopped hiking interest rates, yet.
Here are my thoughts from my USB sell article, which came out in January 2022:
A big change happened this December [2021], however. The US government, led by Senator Joe Manchin, decided that inflation was a problem and that they wanted to withdraw fiscal stimulus from the economy. Combined with that change, the Fed quickly reversed course and decided inflation was a problem as well, and they started decreasing their stimulus of the economy as well. It's my view that pulling stimulus away so quickly will cause a boom/bust environment for stocks, and that unless the government and central bank change course in the next 3-6 months, they'll trigger a bear market. Since I don't want to hold cyclical stocks in a bear market and USB was near its previous high price, I took profits...
... of course, as we have seen, all of this can change in a hurry between now and the end of the year. Once the bear market happens, perhaps inflation will no longer be viewed as negatively as it is right now and the Fed and Manchin will change their minds. We don't really know the answer to that. But what I think we do know is that control of Congress is likely to be split between parties in 2023 and 2024 which will cause gridlock and no new stimulus, so we have a clock that is ticking down to what is basically the end of near-term stimulus, and the odds of a bear market dramatically increase without it. I don't want to own most cyclical stocks in that environment. It's not unthinkable USB could fall -50% off its highs again if we have a 2023 recession.
Well, we had a delay of student loan repayments that were set to resume in early 2022 so we haven't fully pulled back stimulus and that will start in September or October 2023 instead of January 2022. But we got the split Congress, and we got the bear market, and we got the -50% drawdown in USB. I think after student loan payments resume, we have about an 80% chance of a recession. So, because of the nearly 2-year delay in repayments, we pushed back a potential recession perhaps into Q4 2023 or Q1 2024 (and just got a bear market instead), but those repayments will weigh on the economy, and combined with high interest rates and tightening credit, a recession is more likely than not. This is why I wouldn't rush into buying USB stock just yet at today's prices if one has a medium-term time horizon. I think buying right now would put investors in a position of experiencing a significant drawdown over the near term and probably only getting average returns over the medium term.
I do think there is about a 20% chance of a soft landing if more people come into the workforce and we see a shift from some small business owners, or workers in the goods economy, going into the service economy for lower wages. If this happens smoothly it could push services inflation down slowly and allow the Fed to stop hiking, and maybe even lower rates next year. But a lot of things have to go right for this to happen. Historically something goes wrong during this process. I also think there are demographic pressures, with the US having more retirees than ever with Boomers retiring, that demand for younger services workers from wealthier Boomers will remain pretty high. So, while a soft landing is possible, it's not likely, and banks will probably get hit harder than other stocks. With these conditions, I feel comfortable aiming for lower prices before stepping in to buy any regional banks, including USB.
After the 2020 crash, USB stock experienced a remarkably quick recovery that only took 1.5 years. But historically, from peak to peak, recessionary declines have taken 4 to 5 years to recover old highs. I think 5 years would be my base-case expectation this time around given the underlying inflation still in the services economy and the lack of additional fiscal stimulus. The longer an investor expects to wait for the stock price to fully recover, the deeper discount the price needs to be to generate above-average returns. I haven't seen anything to make me think this upcycle will be faster than those which have occurred in 1999 and 2008.
Conclusion
After USB's recent earnings report, I think it's fair to say the immediate crisis of deposits is over and has stabilized. But I don't think the stock has priced in the likelihood of a recession, yet. Investors who think we will avoid a recession, could step in and buy at today's prices. But if you are in the camp that thinks a recession is highly likely, I think it's wise to wait, and the market will likely provide a better price.
For further details see:
U.S. Bancorp: Not Priced For A Recession Yet, Slow Recovery Likely