What’s the big deal?
Bank shares have long been the market darlings of the Australian share market, loved almost universally for both their juicy fully franked dividend yield, and their capital growth.
My guess is that Commonwealth Bank of Australia (ASX:CBA) shares alone have made millionaires out of many ordinary Australian investors.
These are people who bought CBA shares when they floated at $5.40 each in 1991. They likely added to their holdings along the way, reinvested dividends, and doggedly held all their CBA shares through to today.
These same people likely bought other bank shares too, namely Australia and New Zealand Banking Group (ASX:ANZ), National Australia Bank (ASX:NAB) and Westpac Banking Corp (ASX:WBC).
Bank shareholders have partied long and hard on the back of rising property prices and increasingly indebted consumers. Adding fuel to the fire has been record low interest rates and 27 years without a recession.
But the party looks to be coming to an end.
- House prices are falling, with a report on Business Insider saying UBS thinks the downturn could be “the longest in decades.”
- With the RBA cash rate already at an emergency low level of 1.5 per cent, interest rates simply can’t fall any further.
- To date, bank bad debts have been benign. But with mortgage stress on the rise, and consumers struggling to meet day to day living costs, the only way for them is up, something that will crimp bank profits.
- The banking royal commission will almost certainly result in tighter lending criteria for the banks.
What does this mean?
Just by dint of their pure size, banks are already struggling to grow profits and dividends.
Add in lower loan growth and the potential for higher bad debts, and it’s hard to make a case for banks to grow underlying profits by much more than around 2-3 per cent per annum.
Bank shares are not exactly cheap, trading on price to earnings ratios (P/E) of between 12-14 times. Significant capital appreciation for bank shares looks to be a thing of the past.
Granted, bank share continue to look attractive from an income perspective, trading on fully franked dividend yields of around 6 per cent. But if profits fall, so will dividends.
What should you do?
Don’t expect bank shares to be the millionaire makers they’ve been for the past 25+ years.
At best, they are dividend shares only.
At worst, profits fall by 40 per cent, dividends are slashed or even suspended, and Australia falls into its first recession in 27 years.
That scenario is unlikely, and I never like to peddle doom and gloom. The reality for bank shares is they have limited upside opportunity and medium to large downside potential — just about the worst type of investment you can make.
As ever, have a diversified portfolio. If you have too much of your wealth tied up in bank shares, consider selling and reinvesting the proceeds into other growth shares.