The banking sector has had a mildly disappointing quarter, with weak earnings quality offset by improving credit quality. While the drop in non-performing assets (NPA) is good news, it can’t be continued indefinitely and net interest margins continue to come under pressure. Add in price growth that has outpaced the stock market for the last two years and the sector could be headed for a downward correction.

The rapidly increasing earnings void

“As the banks scramble to fill the rapidly increasing earnings void, our sense is the group will trade sideways until a clearer picture of the economy appears and political/regulatory pressure subsides,” write Sterne Agee analysts Todd Hagerman and Robert Greene, pointing out that the downward bias for the sector has increased even if their average price targets have remained in place.

NPAs fell 4-5% and charge-offs fell 15-17% quarter-on-quarter, mostly driven by a recovering real estate market. But NPAs can only save earnings reports for a few quarters before they hit a natural floor. Banks will need to find a way to improve earnings to keep investors happy.

Hagerman and Greene were positive on the sector overall, rating Bank of America Corp (NYSE:BAC) and KeyCorp (NYSE:KEY) as Neutral and Popular Inc (NASDAQ:BPOP), Citigroup Inc (NYSE:C), First Bancorp (NYSE:FBP), JPMorgan Chase & Co. (NYSE:JPM), M&T Bank Corporation (NYSE:MTB), OFG Bancorp (NYSE:OFG), and PacWest Bancorp (NASDAQ:PACW) all as Buys, while not specifically mentioning any bank with a Sell rating.

Banks have outperformed equities in the U.S. since 2011

But banks have already seen their share prices re-rated, now trading at about 15X 2014E EPS and 1.7X tangible book. “We would note that the bank index has seen 2-3x multiple expansion through the year, despite earnings expectations that have largely been held in check,” write Hagerman and Greene. Going back further, banks have outperformed equities in the U.S. since 2011. Even in Europe they had outperformed until earlier this year.

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No sell recommendations, despite negatives

A sector with disappointing earnings, growing valuations, and pressure on margins doesn’t seem like an exciting investment opportunity. Add in the uncertainty over tapering and it’s surprising that there aren’t more sell recommendations floating around, not just from Hagerman and Greene. There’s been a move into European financials on the assumption that the ECB will step in if anything goes wrong, and we could be seeing the same here. Maybe analysts just figure that QE will continue until fundamentals improve, even if they don’t want to say it explicitly.