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Dueling Fools: The Case for Investing in Banks Now

The market teaches us, over and over again, that crisis creates opportunity. Well, we've got the crisis. And, we have the opportunity in beaten-down bank stocks. The time has come to seize the moment.

Banks are essential to a smoothly functioning economy, so they'll come back. And they're dirt cheap. The question is weather to buy them now or wait.

I want my Mommy
Many argue to wait. They certainly have good reasons. There's been no sound or sight of any all-clear sign. Just last week, the credit crisis reduced America's fifth-largest investment bank to toothpicks, and the U.S. and world financial systems are still in peril.

Many economists say we're in the midst of a recession. Some economic forecasts are quite dire. Banks such as UBS (NYSE: UBS  ) and Citigroup (NYSE: C  ) have written off astronomical sums of bad debt, and more huge write-downs are expected for many banks in the upcoming earnings season, with grim projections likely for the near future.

In case all this isn't enough, the economy just plain stinks, recession or no. As in any economic slowdown, banks have less lending activity and less opportunity to make money.

Even if banks do avoid catastrophe and we get through this, the crisis has severely damaged the future earning power of many banks. Noninterest income had come to represent most of the earnings of banks such as JPMorgan Chase (NYSE: JPM  ) , Citigroup, and Bank of America (NYSE: BAC  ) in the robust years. Much of the revenue associated with mortgage fees and repackaging of loans won't return for several years.

Back up the truck, boys, and load 'em up
All of this has made the banks really cheap. How cheap? Banks in the S&P 500 are selling at just 1.2 times book value, the lowest ratio since 1991. As stock prices fall, dividend yields soar.

At the same time, the market seems to be making "worst is over" noises. The willingness of the Federal Reserve to save the market from the fallout of a Bear Stearns (NYSE: BSC  ) bankruptcy and pump liquidity into the credit system has calmed the markets, leading many on Wall Street to believe that this and other possible Fed actions considerably reduce the likelihood of catastrophe.

Also, better than expected earnings from Goldman Sachs (NYSE: GS  ) and Lehman Bros. (NYSE: LEH  ) indicate that large financials could be turning the corner. As a result, last week, financial stocks led the market to its best week in two months.

Although the economy does stink, the best time to by stocks is near the bottom of a recession. In fact, stock market performance in the aftermath of recessions has been astounding. The S&P 500 gained 26% in both 2003 and 1991 following recessions. And it gained 31% in 1975 following the 1974 recession.

Financial stocks in particular have a history of stunning performance following sell-offs. During the savings and loan crisis of 1989-1990, and the Long-Term Capital Management hedge fund crisis of 1998, financial stocks dropped 50% and 34%, respectively, from their highs. Over the two years following the bottoms, these stocks rose more than 50% in both instances.

Although many previous sources of revenue for the banks will not return soon, prices are sufficiently depressed that they don't need to replace that revenue to stage a rally from here. Easing fears alone should give the sector a nice bump in price.

That invisible bottom
Are we near the bottom? Maybe, but you can never be sure. When one buys stocks cheap, it is always with the risk that prices could go lower still. That's why it takes guts.

Here's the thing. Things are bad, and it's scary. But every decade or so, another crisis threatens the economy. And when it does, the sky is always falling. Many said that the savings and loan crisis would cripple the economy in the '90s. In the late '70s, it was said that America had lost its economic prowess, and it was only a matter of time until we fell prey to the Soviet Union. But we always come out of it.

Unless you really know things about companies that others don't, and you have special knowledge or information, you make money in the market by buying good companies cheap. The old-timers will tell you that.

Read Morgan Housel's argument against investing in banks.

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