With the first-quarter earnings season coming to an end, valuations for bank stocks are starting to return to normal, meaning bank CEOs have a problem. After such a period of collective euphoria following the November election, how does the manager of a large institution explain a declining stock price to investors?

The election of President Trump was remarkable in many respects, but in particular it unleashed a period of stock market mania unequaled since the housing boom of the mid-2000s. The trouble is that the messages coming out of Washington tend to be mixed and at times completely inconsistent.

One day we hear that Dodd-Frank Act reform is moving ahead, but the next we learn that a congressional stalemate will sink reform, and then that President Trump remains committed to reimposing the 1930s Glass-Steagall Act separating banking from the securities business. On another day we hear that tax cuts are dead, but then the next President Trump announces an aggressive proposal to cut corporate taxes.

To say that the picture of the future is unclear is a significant understatement. Do we attribute the sharp rise in bank stocks to President Trump or to Federal Reserve Chair Janet Yellen? Or is the more cogent explanation that investors tend to buy on impulse rather than on financial or economic substance? More than anything else, the leaders of America’s banks have to put the performance of financials into larger context.

Normal, to be clear, is defined as the situation that prevailed in the market for bank stocks before the election of Donald Trump to the American presidency Trump’s victory made Wall Street positively giddy with the prospect of rising interest rates and tax cuts. The resulting surge of exuberance took the yield on the 10-year bond up to 2.6% and carried many banks’ stocks up by double-digit rates.

For bank C-suites, the volatility seen in the equity and debt markets is a mixed blessing. It is of course great to see your stock price go up, especially when it is driven by growing volumes and earnings. But the current environment in banks today is mostly characterized by cost-cutting, falling lending volumes and slowly rising credit costs. Thus there really is no obvious rationale for the move in bank stocks, save the change in perception of money managers.

The IShares Financials Index is up about 20% since October 2016, but obviously the banks represented by the index did not see a corresponding increase in either revenue or earnings. What changed were investor perceptions, a fickle indicator that is now in the process of changing again as rates fall.

For example, Bank of America’s stock price was one of the largest gainers, rising nearly 60% over the past six months. Suffice to say that the draconian cost cutting at BAC has finally been recognized, although it remains to be seen whether the bank can maintain the double-digit pace of earnings growth suggested by sell-side analyst estimates.

Even with B of A’s stellar jump in earnings, the bank is still basically trading at book value and sports a return on equity in the high single digits. The average equity returns for all U.S. banks, by comparison, is considerably higher — at about 9.5% — than that of B of A.

In fact, even with the strong earnings results in the first quarter, none of the top U.S. banks, by assets, are currently generating significant positive equity returns above their cost of capital. JPMorgan Chase and Wells Fargo were a bit over 11% ROE, while B of A was just over 7% and Citigroup was 7.4%. Figure the cost of capital for these large banks is in the low double digits.

When you look at these same institutions on a risk-adjusted basis, using the capital weightings for Basel III to score the riskiness of a bank’s assets, the results fall into low single digits, according to Total Bank Solutions. This implies that none of these institutions are really generating profits in an economic sense. Community and regional banks, on the other hand, tend to generate risk-adjusted capital returns well into double digits, in part because these institutions tend not to have large trading books or capital markets businesses.

The good news is that the optimism created by the Republican victory in November has not entirely dissipated. Managers really want to increase their investment allocations to financials. But with the 10-year Treasury yield now below 2.2%, trading momentum for banks’ stocks is starting to wear thin. Not much has really changed in terms of bank earnings and credit over the past six months, so the drop in long-term interest rates is an ominous sign.

Falling rates suggests that the demand for credit exposures remains quite strong, as evidenced by the fact that the U.S. markets are probably going to set yet another record for high-grade debt issuance this quarter. But falling rates also suggests that deflation rather than rising prices remains the chief problem facing the U.S. economy and the Federal Open Market Committee.

If that perception of deflation as the chief risk becomes a reality, and the FOMC puts further rate increases on hold, then the chief rationale behind the sharp upward move in banks stocks — namely rising interest rates — may quickly disappear, leaving many bank investors and bank executives right back where we started in October of 2016.

Christopher Whalen

Christopher Whalen

Christopher Whalen is chairman of Whalen Global Advisors LLC and publishes the Institutional Risk Analyst blog.

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