The winter rally in banks is clearly over, but these stocks could well perk up again as the economy reaches the "sweet spot" of its cycle, says Sally Pope Davis of Goldman, Sachs & Co.

That is the stage at which the economic expansion is obviously losing some steam, but business conditions continue to be healthy in most important respects.

For banks, it means that loan demand is slackening but still brisk while short-term interest rates are at their peak level.

"Banks have quite a number of positives going for them, and that should become more apparent to investors as rate increase fears subside," Ms. Davis said in a recent interview.

The sweet spot is a sports term referring to the part of a tennis racket, baseball bat, or hockey stick delivering optimum power for hitting the ball or puck.

The best recent example of hitting the economic sweet spot occurred in 1984-86, she said. In that period the growth rate of the nation's gross domestic product was still above 3% but flattening.

At the same time, there was a flattening yield curve across the various maturities of Treasury securities as well as generally flattening net interest margins at banks.

And, Ms. Davis pointed out, it was a time of market outperformance for many bank stocks, particularly the regionals, that corresponded with the initial burst of interstate merger activity.

The same period, in the view of some economists, set the stage for one of the rare postwar "soft landings" of the economy, in which business expansion slowed but a recession was postponed.

Bankers, economists, and investment community professionals are keenly watching economic data right now, hoping another soft landing will come into view.

The February rally in banks was due in large part to investor sentiment that the Federal Reserve may be finished, or nearly so, tightening credit to brake the economy.

Ms. Davis said she believes the nearing of the economy's sweet spot has been obscured "by too much attention, and fear, about the condition of the banks' bond portfolios."

While there have been several highly publicized cases of portfolio mismatches that damaged earnings as rates rose during the past year, the majority of banks were not hurt much, she noted.

Is the economic sweet spot approaching again? If so, when might it get here? Meanwhile, what will happen to bank stocks?

"I still think we could get a soft landing rally for the banks," Ms. Davis said this week, "but it could be some distance away yet. There is still impressive strength in the economy."

In the interim, she said, "banks are still struggling with what I call the liability sensitivity hangout." Earnings will probably mark time "until the banks can reinvest their securities portfolio and get some revenue growth," she said.

"We will need to get some confirmation on bank revenues," she said. "Before that happens these stocks are probably going to have trouble breaking out."

Ms. Davis said many banks are telling analysts that their earnings will be "back-ended" this year, meaning that the better growth will take place toward the end of the year.

Skeptical investors will probably take a wait-and-see approach about this, she said, "but the case can certainly be made that there is a tremendous amount of asset repricing yet to happen for the banks."

That includes credit cards at below-market "teaser" rates of interest that can be repriced upward, investment securities that can be rolled over for better returns, and derivatives that might be rolled off portfolios entirely.

As a result, she said "we could very well have a period later where banks will show good earnings growth and compare well with earnings figures for other stocks."

Ms. Davis does not anticipate many signs of this in the banks' first- quarter earnings, due in about a month. But as summer approaches, a shift toward late-cycle behavior could begin.

Over time, however, bank stock prices tend to move in line with GDP growth as well as loan growth, she said. While banks can be good late- cycle performers, the approaching end of a business cycle always dictates caution.

"The chances do seem to be fairly good for a soft landing," she said, "but we would not want to own the banks in a recession."

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