Morgan Stanley (MS) and Wells Fargo (WFC) have more room to run

The financial sector is making a comeback, and it looks to stay there.

Club names Morgan Stanley (MS) and Wells Fargo (WFC), in particular, have perked up recently. Still, we think shares have more room to run.

Banks have been rallying since their recent lows in late August on signs of life in the long-dormant IPO market and hopes for more mergers and acquisitions activity, which could boost investment banking services for Wall Street giants like Morgan Stanley.

It was San Francisco-based Instacart‘s (CART) turn on Tuesday to go public. Shares gained more than 30% on their first day of trading, one day after the newly Nasdaq-listed company priced its initial public offering at the top of the expected range at $31 per share. Venture capital firm Sequoia is Instacart’s biggest investor, with a fully diluted stake of 15%.

The debut of the grocery delivery service came less than a week after U.K. semiconductor designer Arm Holdings (ARM) was listed on the Nasdaq in a blockbuster IPO. Shares closed their first session up nearly 25% last Thursday for a market value of more than $63 billion. However, Softbank-owned Arm has been on a sharp, three-session losing streak — and on Tuesday, it was trading less than 8% above its $51-per-share offer price.

Morgan Stanley did not have a hand in either of those IPOs, but it is a lead book runner on the upcoming IPO of marketing automation company Klaviyo, which disclosed in a filing Monday an increase in the offer range, targeting a fully diluted market valuation of $9 billion. E-commerce company Shopify (SHOP) owns about 11% of Klaviyo shares.

The outlook for the industry overall seems to be turning the corner since a mini-banking crisis erupted earlier this year following the March collapse of Silicon Valley Bank. The S&P 500 Financials sector index, while up about 1% year to date, has gained more than 12% since its 2023 lows in March. The overall S&P 500 index has gained 15% year to date and a little less than that from mid-March levels. (We recently did an in-depth report on all 11 sectors of the S&P 500 and where our 35 Club stocks fit in.)

The crisis of confidence in the banking industry ensued after SVB failed to manage risk and hedge for interest rates as the Federal Reserve continued to raise borrowing costs earlier this year. Other regionals such as Signature shuttered as well, accelerating the market selloff. First Republic was seized by federal regulators and sold for a song to JPMorgan. Tremors spread abroad, too, with Swiss bank UBS taking over its ailing rival Credit Suisse. Big banks, like Morgan Stanley and Wells Fargo, were never in any trouble but were painted with a broad brush of industry distrust.

Several months later, however, it seems like investors want back into big bank names again. Morgan Stanley and Wells Fargo were up 6.2% and 5% in the past five days, respectively, as of Monday’s close. However, those stocks, which were lower in Tuesday’s broader market sell-off, and the rest of the industry do face some uncertainty going forward.

Financial regulators are cracking down on banks with at least $100 billion of assets by increasing capital requirements in a bid to curb the risk of future insolvency issues. In response to the failure of SVB, regulators unveiled proposed changes in July that would require more banks to include unrealized losses and gains from securities in their capital ratios.

Still, Wells Fargo and Morgan Stanley are both well capitalized and haven’t been at risk of a run on deposits, according to the Fed’s latest stress test results. These new rules shouldn’t hit their bottom lines either, but there’s an argument to be made that an increase in capital requirements may weigh on revenue streams from net interest income as lending conditions tighten.

However, Chris Kotowski, senior research analyst at Oppenheimer told CNBC that if implemented, firms would adjust to the new regulations.

“Banks will adapt to capitals over time, but if there’s a sudden increase in capital requirements, you know, in the quarter or two or a year after, they can’t necessarily adjust to that instantly, but they will adjust,” Kotowski said in an interview. “If the capital charge on a certain kind of trading inventory is suddenly 20% more, all the market makers in that trading category are going to want to hold 20% less capital.”

During last week’s Barclays Financial Conference, management at Morgan Stanley said that capital markets are set to improve next year, with 2024 likely being a much better year for the economy as well. This could boost investment banking more broadly because companies will feel less inclined to preserve capital and more confident in going public or making acquisitions.

“We are more confident now than any time this year about an improved outlook for 2024,” Morgan Stanley Head of Investment Management Dan Simkowitz said at the event. “It’s clear to us now that the first half of the second quarter was probably the low point in sentiment around capital markets and M&A.” For context, global M&A value declined by 44% in the first five months of 2023, according to analytics firm GlobalData.

Simkowitz added that Morgan Stanley is seeing “improved execution quality across the capital markets and M&A,” leading him to believe the bank is “in the midst of a sustainable recovery.”

An upbeat economic outlook, along with a pickup in M&A and IPO activity, could certainly boost a dormant and crucial part of Morgan Stanley’s business. Due to the volatile nature of capital markets, Morgan Stanley has been putting a heavier focus recently on wealth management and other recurring fee-based revenue.

Wells Fargo doesn’t stand to benefit quite as much as Morgan Stanley on a pickup in investment banking. However, management’s remarks at last week’s Barclays conference are showing signs of continued recovery. Wells Fargo Chief Financial Officer Michael Santomassimo said the macroeconomic picture is “much better than people would have expected at this point.”

“You still have a resilient employment picture. On the consumer side, the activity is still really good. People are out spending money. You see debit card spend up a couple of percent from what it was a year ago through the quarter,” according to Santomassimo. “You see strong growth in credit card spend, double-digit growth.”

Wells Fargo’s management reiterated the bank’s solid forward guidance while demonstrating an improving efficiency ratio as they continue to cut costs through layoffs and various restructuring plans. “A lack of bad news turned out to be good news,” CNBC Investing Club Director of Portfolio Analysis Jeff Marks said during last Thursday’s Morning Meeting.

The recent comments from Wells Fargo show further progress in the bank’s multi-year turnaround plan after the Fed imposed an asset cap on the firm in 2018. We see the timing of the financial regulator’s decision to lift the asset cap as a “when, not if” scenario, which would allow the bank to not only increase its balance sheet but also generate more profits.

(Jim Cramer’s Charitable Trust is long MS, WFC. See here for a full list of the stocks.)

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