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If you bought Bank of America (NYSE: BAC ) one month ago, congratulations; you're sitting on a four-and-a-half-bagger. Yesterday alone brought a 15% jump on no news at all. Citigroup (NYSE: C ) surged 25%. Moves like that are why people love the stock market. But if you bought either of these in the past few days, in hopes that this party's just getting started, keep reading.
An astute reader yesterday challenged my suggestion that the only things that changed in the past month were investors' emotions, writing:
When you ask the question, "What has changed?" you could have asked the same question about tech stocks in 2003. The answer of course was not much of anything. People had woken up and realized the valuation they had previously been applying was insane.
That's the rationale many investors use to pile into bank stocks. Not unlike the bargain opportunities of Amazon.com (Nasdaq: AMZN ) or Yahoo! (Nasdaq: YHOO ) after the dot-com bust, bank shares seemingly present an incredible opportunity to "buy when there's blood in the streets."
While that's respectable and logical, the theory deserves to get a few holes poked in it.
Poke, poke, poke
The difference between buying a bargain stock and getting burned on a value trap like General Motors (NYSE: GM ) or, ahem, Bank of America, is your ability to accurately value the company going forward. Unfortunately, accurately valuing banks in this environment requires a skill no less miraculous than parting the seas.
With tech stocks, we were talking about the growth of the Internet -- complicated, but not impossible to grasp. With bank stocks, we're talking about dissecting and interpreting trillion-dollar balance sheets filled with assets so bewildering, the bankers themselves don't understand them. And that doesn't even account for banks' reliance on the capital injections of a fickle government, which has changed bailout tactics at least three times since last fall.
Force yourself to honestly answer these two questions before you jump into bank stocks:
1. How much will the company earn over the next few years?
We're looking at an industry that will be completely flipped upside-down, thanks to impending regulation and voluntary avoidance of previously imploded profit centers. If your plan for estimating future profits involves looking at what banks earned in previous years, and assuming we'll eventually revert to "the norm," know that bank earnings were just as much of a bubble as home prices.
On that note, understand how incredibly difficult -- if not impossible -- it is to judge banks' earnings potential. For example, B of A's acquisition of Merrill Lynch nearly blew up after a surprise quarterly loss of $13.8 billion. As The New York Times described the losses, "One Merrill Lynch trader apparently gambled away more than $120 million in the currency markets. Others seemingly lost hundreds of millions on tricky credit derivatives." That isn't the kind of stuff any honest investor can accurately predict.
2. Where will the capital come from?
With the exception of maybe Goldman Sachs (NYSE: GS ) , every major bank remains sparsely capitalized in terms of tangible common equity -- which counts most for average investors. Even Wells Fargo (NYSE: WFC ) , fresh off of news that it's apparently gushing profits, has a tangible common equity ratio of around 3.1% -- roughly half of what banks keep as historical norms.
The most feasible way for a bank to bolster its common capital is to convert government-issued preferred stock into common equity, just like Citigroup did in February. While that will reliably keep most banks alive, it comes at the cost of crippling dilutions to existing shareholders. For most banks, it isn't a matter of if, but when and how much capital they'll need.
There's nothing wrong with investing in bank stocks today, as long as you take it for what it really is -- primarily an exercise in hoping other investors' optimism will stay alive longer than you plan on holding the stock. Without further details (most banks haven't even reported official earnings yet), we're truly looking at blind optimism, rather than shrewd investing.
Don't let these gains go to your head. People have also made huge fortunes playing dice. That doesn't mean it's a rational thing to do.
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