Germany's Biggest Banker Downgrades JPMorgan and PNC: What You Need to Know

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

It's bad news for investors in U.S. financial giants today, as Germany's biggest bank has announced a pair of downgrades on two of America's biggest banks. This morning, Deutsche Bank said it is pulling its buy ratings on both JPMorgan Chase (NYSE: JPM) and PNC Financial (NYSE: PNC), cutting both stocks to neutral.

The question is: Why?

1. Dialing back banking risk

First of all, this is nothing personal -- just business. Deutsche Bank says it's seeking "to lessen exposure to traditional banks." That makes JPMorgan a logical target. With $2.56 trillion in total assets (per S&P Global Market Intelligence) data, JPMorgan is America's biggest bank by far. What's more, JPMorgan stock is up 42% over the past year, and trading near its 52-week high. If Deutsche were looking for an excuse to take some profits off the table, JPMorgan stock seems a good place to start.

PNC, ranked as the No. 8 largest U.S. bank with $372.2 billion in total assets, is a less obvious choice for downgrading. Then again, PNC Financial stock is up even more strongly than JPMorgan's over the past year. Also near its 52-week high, PNC stock has gained 52% over the past year -- twice the gains posted at No. 7 U.S. bank US Bancorp, for example, and three times the stock performance of No. 9 U.S. bank Capital One. That fact alone might help to explain why PNC is next in line to see its buy rating axed today.

2. Why "lessen exposure" now?

Why cut these stocks' ratings now, though? Why not last week, or last month? As explained in twin write-ups on this morning, the answer to why JPMorgan and PNC are both getting the axe is basically the same.

Last week, Fed Chair Janet Yellen described the U.S. economy as basically "good," and told reporters that in her opinion, the economy is strong enough to absorb another rate increase later this year. At least three other Federal Reserve officials echoed this view, expressing a willingness to raise short-term interest rates once more before the end of this year, and (presumably) to proceed with the three-quarter-point rate increases scheduled for next year as well.

3. What a flat yield curve means for investors

Based on this new information, Deutsche is projecting that the yield curve in the U.S. will flatten -- and you know what that means. It means that banking profits dependent on the difference between short- and long-term interest rates will shrink as the difference between those rates also shrinks (i.e., "flattens").

This, in Deutsche Bank's view, is a recipe for higher costs and "slowing" growth in profits from net interest income at "traditional banks" like JPMorgan and PNC. With both stocks up so much, Deutsche is of the opinion that any good news accruing to these banking stocks is likely "priced in," while the risk of slowing growth may not be.

In Deutsche's opinion, therefore, it's time to take profits out of traditional banking stocks, and roll them instead into bankers that have more of a "turnaround angle" to them -- scandal-plagued Wells Fargo (NYSE: WFC) perhaps, or even cheaper Goldman Sachs (NYSE: GS).

The most important thing: Valuation

Selling for 16.9 times trailing earnings, and 13.8 times, respectively, neither PNC Financial stock nor JPMorgan looks particularly cheap -- especially in light of consensus projections for mere high-single-digit growth rates at both banks over the next five years. Given how the valuations look at both stocks, I'm inclined to agree with Deutsche in thinking that their runs are just about done. That being said, do Deutsche's suggested alternatives look any better?

At 13.3 times earnings, Wells isn't a whole lot cheaper than JPMorgan, and Wells carries considerably more reputational risk, if you ask me. Moreover, with most analysts forecasting no better than 7% long-term earnings growth at Wells, the stock's actually expected to grow slower than either JPMorgan or PNC. Like Warren Buffett himself, Deutsche Bank seems to see a bright future for Wells Fargo, but if you ask me, these numbers don't exactly scream "turnaround."

Goldman Sachs, on the other hand -- now here I see some potential. At 12.1 times earnings, Goldman Sachs is arguably the cheapest stock in this grouping of megabankers. What's more, S&P Global data show Goldman Sachs' earnings poised to grow at a 12% annualized rate over the next five years. That works out to about a 1.0 PEG ratio on the stock and, combined with Goldman's modest 1.3% dividend yield, I think it makes Goldman Sachs stock the best bargain of the bunch.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.