When to Buy Bank Stocks

While bank stock prices get pummeled as the industry battles a two-headed monster of unending write-offs and a possible recession, the question that's on everyone's mind is, is it time to start buying?

In the name of everything holy, wait
Subprime loan debt is spreading through the financial system like a crack in a windshield. We don't yet know the extent to which debt infected by the crisis has infiltrated the balance sheets of financial companies worldwide: Every quarter, look no further than the banks that continue to write off astronomical sums. As a result, they must reserve an ever-increasing amount of cash to cover present and future losses.

This is devouring cash once used for activities that boost stock values, namely repurchases and dividend payments. Also, as cash reserves are depleted, companies such as Wachovia (NYSE: WB  ) are issuing new equity in the form of preferred and convertible securities to raise more cash, and Morgan Stanley (NYSE: MS  ) , Merrill Lynch (NYSE: MER  ) , and MBIA (NYSE: MBI  ) are receiving cash infusions from outside sources. As desperation for this cash continues, it becomes more likely that some banks will be forced to cut their dividends, thus making their yields lower.

In case the unending write-offs aren't problematic enough, last week the Institute for Supply Management (ISM) reported that service sector activity fell to a recession-like 41.9 in January. The service sector accounts for two-thirds of U.S. economic activity, and this number represents the worst month-to-month decline ever (a number below 50 is considered a contracting economy). This number really matters because it exposes two enormous problems for banks.

First, banks constitute a huge chunk of the service economy, so the number mirrors a slowdown as they loan out less money for business and personal ventures. Second, a slower economy exacerbates already-existing credit problems as borrowers default on more loans because they lose their jobs and fall on harder times. So, consumers are less likely to borrow money and less able to pay for money they've already borrowed. The number prompted several brokerages to downgrade American Express, Wachovia, Wells Fargo (NYSE: WFC  ) , Bank of America (NYSE: BAC  ) , and others.

So buy already
What a mess. But, take heart. We've been down this road before, sort of. During the savings and loan crisis of 1990 and the long-term capital crises of 1998, financial stocks dropped 50% and 32%, respectively, from their highs. Over the next two years, these stocks rose 50% from the bottom.

That's great! If someone could kindly direct me to the bottom, I'll enrich myself. Where is the bottom? It is this Fool's opinion that things will get worse before they get better. We won't see the bottom until several things happen. First, banks and financial institutions announce more catastrophic write-offs. Second, more banks cut dividends. Third, we move further along into the recession/slowdown. And finally, the technical charts for financials improve. These stocks are undergoing a structural breakdown that needs to be reversed.

It's probably too early to start buying bank stocks now. But, things change fast. Now is the time to pick your stocks and set your price. The best way to invest is to calmly and analytically map out your strategy ahead of time. Don't wait and try to make intelligent decisions in the midst of an emotional whirlwind dictated by the market.

The opportunity to buy the highest-quality companies on the cheap in an industry essential to the function of capitalism in the United States is quite rare. Buying companies like Wells Fargo, Bank of America, and US Bancorp (NYSE: USB  ) when no one else wants them has proven to materially affect the long-term returns of a portfolio. When the dust settles, you just might have a chance to make the investments of a lifetime.

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