With one month left to go in 2023, stocks seem set to finish the year with a big win.
Through the end of November, the S&P 500 index is up 19%, while the Nasdaq Composite has jumped a whopping 36% this year, paced by excitement over new AI technologies. In addition to the AI boom, stocks have also benefited from a resilient economy, generally strong earnings reports, and inflation falling faster than expected.
However, not every stock has been a winner this year. Among those that have struggled are regional bank stocks, as the sector plunged in March when Silicon Valley Bank went under. Since then, regional banks have faced pressure from elevated interest rates -- which have led to competition for deposits, meaning they've had to raise the rates that they're paying for deposits -- economic uncertainty, and the threat of tighter regulations in the aftermath of the crisis.
You can see the weak performance from iShares U.S. Regional Banks ETF (IAT -0.31%) in the chart below.
The ETF is down by 22% this year, underperforming the S&P 500 by more than 40 percentage points. However, long-term investors know that this year's stock market trash can often be next year's treasure. Just look at tech stocks in 2022 versus 2023. Similarly, regional banks, which now seem undervalued, look like good candidates for a recovery. Let's take a closer look.
Image source: Getty Images.
A year to forget
The banking sector tends to be highly cyclical, and that's even more true for regional banks, which lack the diversification of national banks and have more exposure to small and medium-sized businesses, which also tend to be more volatile.
Banks benefit from stable economic environments, and 2023 was anything but that. In addition to the regional banking crisis, the sector was buffeted by rising interest rates, fears of a recession, and expectations of tighter capital requirements.
However, regional banks have actually performed reasonably well in this challenging environment. Take a look at the iShares U.S. Regional Bank ETF's top three holdings -- U.S. Bancorp (USB 0.32%), PNC Financial Services (PNC -0.12%), and Truist Financial (TFC 0.53%), which make up nearly 40% of the ETF's net assets.
U.S. Bancorp has reported an 8.3% increase in operating income to $7.1 billion, though part of those gains is due to its acquisition of MUFG Union Bank (MUB).
PNC's operating income has increased a modest 1.6% to $5.68 billion over the same time frame, while Truist was the only one of the three to post a decline in operating income, falling 12% to $4.97 billion, due to higher provision credit losses, lower net interest margin, and higher personnel expenses.
Altogether, despite Truist's decline, those numbers don't portray an industry in crisis or one that deserves a 22% sell-off.
Redemption for regional banks
Heading into 2024, there are a number of signs that things could improve for regional banks. Interest rates are expected to start coming down, which could ease deposit rate pressures and encourage more lending, especially in the mortgage market. Additionally, economic growth is expected to trough, and the beginnings of a rebound in the economy should support improving valuations in bank stocks as the risk of a recession fades away. A healthier economy should also support increased borrowing and consumer spending, driving more business for the regional banks.
Considering that outlook, the iShares U.S. Regional Banks ETF seems to trade at a discount, valued at a price-to-earnings ratio of just 8.6 and offering a dividend yield of 4.6%.
Buying shares in the ETF is a good way to get exposure to a wide range of regional banks at a low price and take advantage of the generous yield. Investors should start to benefit from a recovery in regional bank stocks next year as the economy stabilizes, interest rates start to come down, and memories of the Silicon Valley Bank collapse fade.