Banks as a group have been some of the best-performing stocks over the last few years, roughly tripling in value since the industry bottomed out at the beginning of 2009. But this performance shouldn't be interpreted to mean that there's a stock market bubble in bank stocks.
Bubbles from our recent past
A bubble occurs when the valuation of an asset class, or the market more generally, outpaces reasonable projections for the class's fundamental economic performance over the foreseeable future.
In the late 1990s, for instance, stocks with little revenue and no earnings were bid up to astronomical prices based on the belief -- soon to be proven wrong -- that the Internet would rewrite the rules of commerce. The same thing happened to home values, which typically generate no income whatsoever, in the lead-up to the financial crisis of 2008-2009.
In both cases, the departure from historical valuations was obvious even to the naked eye -- although, of course, I'm speaking with the benefit of hindsight. In roughly a year and a half, starting in August of 1998, the Nasdaq Composite Index more than doubled in value. A similar, albeit more gradual, trend captured housing in the years leading up to the recent financial crisis.
Bank stocks aren't following this path
With this in mind, you'd be excused for concluding that a tripling of the price of bank stocks over the past six years must mean that a stock market bubble has besieged the industry. But there are two reasons to feel confident that this isn't the case.
First, bank stocks haven't tripled in price over the last few years because investors are irrationally bidding them up. Rather, they've soared because of where they started from -- that is, the dramatic ascent has simply helped bank stocks recover from the beating they took during the financial crisis.
You can see this by looking at the KBW Bank Index, which tracks two dozen of the nation's leading bank stocks. From 2007 to 2009, it lost 75% of its value as investors fled the sector, and lenders like Bank of America and Citigroup diluted their remaining shareholders with new shares of stock issued at deeply distressed values. Since then, it has still only partially reclaimed the lost ground.
And the second reason is simply that bank stocks aren't trading for outrageous valuations right now. Even the best banks -- U.S. Bancorp, for example -- are available for less than two times book value, which history tells us is a high yet sustainable level. And the worst banks, such as Citigroup and Bank of America, are trading for double-digit discounts from their shareholders' equity.
Indeed, in my opinion, one shouldn't be remotely concerned that bank stocks as a whole are irrationally overvalued unless even the industry's laggards are trading for multiples in excess of three to four times book value.
