“Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”
– Sir John Templeton
While I think there is only one generational opportunity in the financial markets right now, which is more specifically in the historically out-of-favor and discarded commodity sector with a focus on energy stocks, there are other overlooked sections of the market that have been disproportionately hard hit by the COVID-19 pandemic, and which have yet to recover fully. This is creating a significant contrarian opportunity.
Building on this narrative, many investors, including myself, have been combing through the downtrodden REIT sector, as many REIT stocks were walloped by the abrupt shift to a stay at home economy, which benefitted companies like Amazon (AMZN), Netflix (NFLX), and Zoom (ZM), yet hurt most REITs. Thus, there were bargains to be had, as I identified with my bullish July 2nd, 2020 article on Simon Property Group (SPG), which has materially outpaced the S&P 500 Index (SP500) on a total return basis, since its publication date.
Over the past six months, the economic and stock market recovery has continued, with third quarter 2020 U.S. GDP growth advancing at an annualized rate of 33.1%, and fourth-quarter GDP estimates rising materially in recent days. Specific to the stock market, the S&P 500 Index, the Dow Jones Industrial Average (DIA), and the Russell 2000 indices have all made new all-time highs.
Standing out like a sore thumb in this environment are shares of Wells Fargo (WFC), which is the largest commercial real estate lender and loan holder in the United States, and a top residential mortgage lender too. Shares of WFC are still down 43.6% year-to-date in 2020, even after a recent rally off the year-to-date lows. With the economic recovery advancing strongly, signaled by strong U.S. GDP growth, commodity prices, housing prices, and a booming stock market, it is only a matter of time until Wells Fargo shares catch-up, from my perspective, creating a contrarian large-cap opportunity hidden in plain sight.
Wells Fargo Shares Are Pummeled Year-To-Date
Financial stocks have been under pressure in 2020, and Wells Fargo shares are down 43.6% as of this writing.
Down 43.6%, as Wells Fargo shares are in 2020, when the S&P 500 Index, as measured by the SPDR S&P 500 ETF (SPY), is higher by 14.3% year-to-date, and the more economically sensitive Russell 2000 Index, as measured by Russell 2000 ETF (IWM), is higher by 12.1% is one relative performance figure that stands out. Even more eye opening is the fact that the Financial Select Sector SPDR ETF (XLF) is only down 5.3% YTD in 2020 and the Vanguard Real Estate ETF (VNQ) is only down 5.8%, which should both be better peer comparisons for Wells Fargo shares.
Clearly there has been a negative divergence between Wells Fargo shares and the broader market, including the red-hot Invesco QQQ ETF (QQQ), which is the fulcrum of the stay at home FAANG stocks, and a negative divergence between Wells Fargo shares and the financial sector and the real estate sector. However, is this divergence justified, given that financials, commercial real estate, and residential real estate are all recovering?
Wells Fargo Is The Largest Commercial Real Estate Lender And Second Largest Mortgage Lender
A little over four months ago, before the promising COVID-19 vaccine news, first from Pfizer (PFE) and BioNTech (BNTX), then Moderna (MRNA), and more recently AstraZeneca (AZN), there was considerable doom and gloom in both the mortgage market, where Wells Fargo had been the largest originator before being passed recently by Quicken Loans (RKT), and in the commercial loan market.
This snapshot of an article from American Banker captured the mood succinctly.
Like most of their large banking peers, including JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C), and U.S. Bancorp (USB), Wells Fargo dramatically boosted loan loss reserves in the second quarter of 2020 compared to the first quarter of 2020.
At the time, many analysts thought there were more upward revisions of loan loss reserves to come, especially given Wells Fargo’s absolute size in the aforementioned commercial real estate and residential mortgage markets, which is shown by selected second quarter ending commercial retail outstanding exposure and mortgage origination data from S&P Global (SPGI) below.
Looking back to four months ago, fear was at a crescendo. Wells Fargo was buying back originated mortgages that investors feared would have further losses (not to mention they were being limited by regulatory penalties), and the company had just announced an 80% dividend cut. With this backdrop, it is not surprising that shares were sold by everyone from Warren Buffett, whose Berkshire Hathaway (BRK.A) (BRK.B) reduced their position in Wells Fargo to a 17-year low, to retail and institutional investors of all stripes.
Since that peak of fear, however, the U.S. economy has enjoyed a renaissance that effectively transitions an enormous headwind for Wells Fargo shares into an enormous tailwind, which is amplified by their relative and absolute size in the commercial real estate and mortgage markets.
U.S. GDP Growth & Global Economic Growth Are Surging
Most analysts expected a strong bounce back in third quarter 2020 U.S. GDP growth, and that is indeed what we have gotten thus far, as real gross domestic product increased at an annualized rate of 33.1% in the third quarter of 2020, according to data from the U.S. Bureau of Economic Analysis.
This was at the high end of expectations, yet the bigger surprise has been the increase in the estimated fourth-quarter GDP growth rate, as shown by the Atlanta Fed’s GDPNow model below.
(Source: Atlanta Fed GDPNow)
Against almost all expectations, estimated fourth-quarter GDP growth is surging, as economic data from durable goods orders to new home sales exceeds expectations, fueled by recovering demand, and still ultra low long-term interest rates.
In fact, U.S. home prices have hit new record highs too, joining the record highs in the broader stock market.
A combination of reduced supply from years of new home building that struggled to recover in the aftermath of the 2008/2009 downturn, and record low interest rates are behind the surge in home prices to new all-time highs. One would think that resilient real estate prices would be very good for those banks with large loan books like Wells Fargo, and I believe that is the correct stance to take at this time.
Banks Are Better Than REITs Right Now For Real Estate Exposure
Interest rates are still extraordinarily low, both in the U.S. and around the globe, as the bond market has diverged materially from the commodities market and the global stock markets.
In fact, the U.S. 10-Year Treasury Yield is still far closer to its recent pandemic lows than the relatively calm days of 2019, as the chart below shows.
Just looking at the chart of longer-term interest rates, it is easy to see the near-term correlation with Wells Fargo’s share price.
The key phrase here is near-term correlation, speaking of the move down in U.S. 10-Year Treasury Yields and Wells Fargo shares in 2020. Adding to the narrative, many expect longer-term yields to stay lower for longer, with the U.S. Federal Reserve recently even hinting at shifting their mix of bond buying to favor longer duration bonds.
However, against this backdrop, the U.S. yield curve is actually steepening, with longer rates rising relative to nearer term interest rates.
This steepening of the yield curve has been ongoing since the middle of 2018, and I believe this quiet steepening of the yield curve has been a primary driver behind broader REIT underperformance for much of the past two years, looking beyond the current recovery in REIT shares from the heart of the pandemic lows.
Ironically, a steeper yield curve is actually very beneficial to the banking sector, boosting their net interest margins, so I think financials should be preferred over REITs at this juncture, as most REITs, particularly the higher quality net lease REITs, are really effectively very similar to holding longer-term Treasurys, at least in my opinion, and from the research I have done on this topic.
Building on this last point, with my August 14th, 2020 article on Realty Income (O), titled, “Realty Income Shares Have Gone Nowhere For 4 Years“, I showed that Realty Income shares have just run in place, providing a nice monthly coupon that has masked the running in place. Specific to Wells Fargo, an investor is getting substantial exposure to real estate, both commercial and residential, through the loan book of Wells Fargo, so this is a superior way to play the ongoing recovery in both commercial and residential real estate in my opinion.
Wells Fargo shares offer a unique opportunity to have discounted exposure to recovering commercial and residential real estate prices, fueled by rising economic growth expectations. Shares of Wells Fargo offer a superior return option to most REITs, due to their unique benefit as a bank from a steepening yield curve, which will drive net interest margins higher. Lost in the current year-to-date share price decline is the fact that Wells Fargo is the largest commercial real estate lender, with the largest loan book, and they are the second-largest residential mortgage lender, so they benefit in a unique way from recovering real estate prices.
Compared to their large-bank U.S. peers, including JPMorgan Chase, Bank of America, Citigroup, and U.S. Bancorp, Wells Fargo shares have dramatically underperformed, declining 43.6% in 2020, and now trade at a roughly 14 price-to-earnings multiple going forward. For comparison, Citigroup shares are down 25.7% in 2020, U.S. Bancorp shares are down 21.9%, Bank of America shares are down 15.9%, JPMorgan Chase shares are down 9.3%, and the Financial Select Sector SPDR Fund is down 5.3% YTD.
Compared to the broader stock market, with the S&P 500 Index up 14.3% YTD to new all-time highs, there is a marked divergence between what is happening in the broader stock market and with what is happening in the financial sector. If GDP growth continues to exceed expectations, investors should expect long-term interest rates to rise further, the financial sector to close the gap with the broader stock market, and Wells Fargo shares to outperform their peers, as what was once viewed as a liability, specifically very large loan books in the commercial and residential real estate sectors, becomes a significant asset.
There is historic opportunity in the investment markets today. I have spent thousands of hours analyzing the markets, looking for the best opportunities, looking to replicate what I have been able to accomplish in the past. From my perspective, the opportunities in targeted out-of-favor equities today are every bit as big as the best opportunities in early 2016, and late 2008/early 2009. For further perspective on these opportunities, consider a membership to The Contrarian, sign up here to join.
Disclosure: I am/we are long WFC, BAC, C, SPG, AND SHORT SPY IN A LONG/SHORT PORTFOLIO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Every investor’s situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including a detailed review of the companies’ SEC filings. Any opinions or estimates constitute the author’s best judgment as of the date of publication and are subject to change without notice.