Euphoria Ignites Bank Stocks

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.

For related Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Amazon.com is a Motley Fool Stock Advisor pick. The Motley Fool has a disclosure policy.


Read/Post Comments (17) | Recommend This Article (52)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 14, 2009, at 4:12 PM, ranchr wrote:

    If you bought BAC 20 minutes ago, you lost money. If you bought 30 seconds ago, you made 5 cents and, if you bought this morning you lost at least a buck. If you bought last fall at $20 rode it up to $37 and sold at $34, like I did you made a pile of money. And, if you jumped back in BAC at $7.28 waited through the really dark days and are still hold, like I am, on paper, I've made another bunch.

    Point is,if you are playing blackjack and trading daily, lady luck has more to do with your success than skill. If you invest and sell either because of a tight stop or you reach a predetermined price, or invest for the long term, you're playing a totally different game.

  • Report this Comment On April 14, 2009, at 4:15 PM, FinancialFellow wrote:

    I actually bought into Citi several months back at $3.20. Since then it's gone up to $8 then down to $1. Now it's back at $4.50. I wholeheartedly agree that all of this is purely speculation.

    I trust that Morgan is correct in the importance of evaluating bank stocks on their fundamentals and, how difficult it is to evaluate a bank's bottom line in this current environment. That said, I'm of the opinion that there's one big question that investors have been asking themselves: Will Citi go bankrupt or not? The answer to that question is what is really driving the stock price. Good earnings from banks - even with all the unknowns about their balance sheets - decrease the liklihood of bankruptcy.

    Another financial related investment that I think should be explored more invovles companies that perform credit monitoring/identify theft insurance. It's a booming business with more and more traditional companies offering the services. I'm sure you've seen an ad for Lifelock. (They're actually a privately held company). I evaluated their identity theft protection recently: http://financialfellow.com/2009/01/22/is-lifelock-worth-the-...

  • Report this Comment On April 14, 2009, at 5:03 PM, jakman72 wrote:

    any pruchase you make whether bank or not is spectulation. most of what spectulators do is guess. guess right,$$$$. guess wrong, boo hoo.Fitb has made the money if guessed right. i made the money, go banks.

  • Report this Comment On April 14, 2009, at 6:15 PM, Redrocktom wrote:

    I am wondering if the banks' newly found profits come from relaxation of mark to market rules that had required setting aside loan loss reserves. Maybe some of these reserves have been converted back to assets, creating "income". Anybody know anything about that?

  • Report this Comment On April 14, 2009, at 6:23 PM, Fliujniligui wrote:

    Well, this is true that trillion balance sheets of banks are something which is uninterpretable, but I disagree in part with this text. Some banks have billion or trillion dollar balance sheets consisting of traditional banking business. There are many of them outside the USA and in there. EWBC and NARA just gather the deposits of Koreans and Chinese Californians who are cash flow positive and do not engage in securitization and subprime risk lending. You can buy their tangible common equity for 25¢ on the dollar and their capital ratios are fat. Toronto Dominion just does business as usual in Canada and it just gave me a dividend that other day, 61¢ Canadian per share. Cheap bank stock for the quality. National Bank of Greece holds, as its most toxic asset, Government of Greece Bonds. You can live with that. This is erroneous to generalize that banks are risky as an asset class, banks all sinked as an asset class and picking the best ones at those price, even after the rally, makes sense on the long term.

  • Report this Comment On April 14, 2009, at 6:28 PM, whizziee wrote:

    In RE: bank stocks, its this simple 2 plus 2 is 4, its never 5. These banks have serious problems and they are not going to be wished away. They are a a high risk gamble and not worth trying. Another revelation and a trip before Congress and they will drop like a rock.IF they can stay off the front page of the newspapers they can recover slowly.

  • Report this Comment On April 14, 2009, at 6:33 PM, sailrmac wrote:

    "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."

    Which is why securities senior to the stock and preferred (ex. Citigroup trust preferred) are an investment not a speculation.

  • Report this Comment On April 14, 2009, at 7:32 PM, 7footmoose wrote:

    Saying that you are investing in bank stocks at this time is a misnomer since it is more akin to playing roulette possibly even Russian Roulette. No one can reliably predict the impact of souring loan portfolios on the future "net profits" of the industry much less an individual bank. Currently "operating profits" are likely to be quite good. That is usually the case when the cost of deposits( the bank equivalent of raw material) is near zero and you are able to charge historically high interest margins to borrowers. Changing consumer patterns of both savings and borrowing are likely to cause changes in traditional bank business models. Continuing erosion of real estate values both residential and commercial are likely add to losses in foreclosure. And, the true wild card in this investment is the United States Government who just might be the bank's new lifelong partner in corporate strategic decisioning.

  • Report this Comment On April 14, 2009, at 10:55 PM, courtneTHEgreat wrote:

    Here I go again.... I predict another major down turn in the DOW (5900), but I see something with BAC and maybe C that needs to be added to our thinking.

    BAC has reduced its dividend. That means more money in its pocket. There is a major credit card issue coming where unemployed people cannot pay their debt. Of course, the housing issue is added to the mix.... All these issues are not over and new families are added to the woes daily.

    With this added together, BAC may or may not meet its numbers on 4/20 (did you see the prediction?? such a wide range!). But, is it possible for a bank to fail? If it wants to, yes, but I think BAC will want to shine.

    Fools, is it wise to buy CALL options on the next major dip of BAC? I see the high in '09 to be $15 with a possible low of $5.

    Your thoughts....

  • Report this Comment On April 14, 2009, at 10:57 PM, sentinelbrit wrote:

    I agree that some/many banks are technically insolvent - in that their liabilities exceed their assets. The market knows this. But the market also realizes the Fed is underwriting the banks (the bears repeatedly point out that taxpayers are getting ripped off and it's unfair etc as a way of justifying their position on bank stocks, which I find ironic). It is terribly difficult to assess a banks' earning potential at the present time. But that should not stop us trying. It would be a worthwhile exercise for the author to come up with some guidelines for estimating earnings - pre write downs or write offs. That's what analysts will try to do - it's not very helpful to just say - banks are a mess and I'm not going to touch them. Let's at least have some hard analysis so we can see the potential rewards and not just the risk. As one person noted, the banks are making a huge spread on the cost of borrowing from the Fed (virtually zero) plus what they have to pay on deposits and on the other hand their lending rates.

  • Report this Comment On April 14, 2009, at 11:00 PM, nuf2bdangrus wrote:

    Want to buy a bank stock? I have one question for you: RED or BLACK?

  • Report this Comment On April 15, 2009, at 6:48 AM, jboday wrote:

    The entire industry has (rightly so) been beaten to a pulp. Instead of speculating on a particular bank stock, why not buy the whole financial industry by buying an ETF such as Vanguard Financials ETF (VFH)? It is not likely to go up as much as some individual stocks. And while some banks may yet disappear I'm willing to speculate that the banking industry will be around for a while. And has no where to go but up.

  • Report this Comment On April 15, 2009, at 7:42 AM, jtroth1 wrote:

    come on people. lets look at this logically. Citigroup is probably not going to fail given its claws are sunk into so many different facets of our financial world. The question is not whether or not we can make money off of it but how much money we can make. 45 days ago when there was all this doom and gloom and it was down to 1 dollar per share would have been the best time to buy. You would have already quadrupled your money. now is still a good time. It will eventually be back up to the 15 dollar mark when things stabilize. Unless you want to go join some kinda armageddon fan club and convince yourself these are the end times.

  • Report this Comment On April 15, 2009, at 2:12 PM, yukonmike wrote:

    The question you have to ask yourself when you buy a stock is:

    Am I speculating or investing?

    By rule, when you invest in something, you should be able to aptly predict where that business should go inthe foreeable future.

    Fact #1 on banks: We have no idea what's truly going on.

    Example: Goldman Sachs just had a blowout quarter. A FOUR month QUARTER!!!

    Example: Wells Fargo beat expectations. Somehow, they only had to set aside HALF of the loan loss provisions that they had to the quarter before and this was including the integration of Wachovia.

    Smoke and mirrors people, smoke and mirrors.

    So if you want to speculate, go for it, but it is a complete and total crapshoot as the future is about as clear as my septic tank.

  • Report this Comment On April 15, 2009, at 3:29 PM, withoutlimits wrote:

    The derivatives aren't being considered.

    Major losses.

  • Report this Comment On April 15, 2009, at 3:54 PM, LeeRMusser wrote:

    Saying that "there is nothing wrong with investing in bank stocks today" is borderline fraudulent. You said in YOUR OWN PIECE that the people that work there can't even value what is on the balance sheet. Who in the world taught you that it is smart and sound to speculate like this? Anyone who is investing in CITI, B of A, et la are complete idiots. I don't care if they are flush with all this "gov money." (read: my generations future wealth) You can't just keep throwing good money after bad. There is a reason that CITI KEEPS asking for money and squandering it away. It's because their business model is toxic and the people in control are nothing more than high stakes gamblers.

    Wells might be a little bit of a different story. I don't really want to focus on that. All I can say is that if you are "investing" in these bank stocks you are delusional. Stop speculating on earnings news and find a company that actually has the potential to grow their per share intrinsic value at above average rates for decades to come.

    Find companies that are actually going to exist in 5 years. Pay for less than you are getting. Actually start investing and NOT speculating. Stop watching CNBC and actually learn what is important. Stop talking and start doing. There are opportunities everywhere so stop trying to piggyback off of what everyone else is doing, go against the crowd, follow your heart, and you will do well in the long term.

    There is a reason that there are only a handful of money managers who have consistently beat the market over the long term. This is because most don't know what they are doing. They are over diversified and are constantly trying to profit in the short term by doing what this article is prescribing. To invest in B of A one day and try to time when to sell it a few days later. This is NOT investing. We have people like you to thank for the public s current disdain of investment. You, and all your speculative cohorts, have crushed our economy. Nothing infuriates me more.

    Also, to say the words GM and value in the same sentence is laughable. Anyone who is putting money in GM right now has not clue what they are doing. No one, not even Buffett, can time the market in the short term. If you do make money on this trade it is just a coincidence and if you continue to do this you will be broke.

    How about giving your money to someone who knows what they are doing? Stop listening to your broker. If they knew the secret to stock market riches they would not be making 500 phone calls a day trying to sell things. Search out those people that do know what they are talking about, are transparent, will actually preserve your principal investment, and will give you above average returns. Those people are out there. Find them and STOP giving money to these huge bank holding companies. Is it not obvious that they do not know what they are doing? Look at the economy right now. We are here because of them.

  • Report this Comment On April 15, 2009, at 8:19 PM, yukonmike wrote:

    Mr. Author,

    I went back and read your article again because, well, I don't know why, it was pure drivel.

    I take sincere issue with you quoting the great Warren Buffet to "buy when there's blood on the streets" as it's exactly the opposite of what the afformentioned Oracle of Omaha is doing with bank stocks. Sure, he took a position in Goldman, a position that would pay him MINIMUM of 10%/yr on his pfd positions, yet he cut his stakes in financials back substantiall'y. I think that using the quotation itself implies that this is somehow a safe time to invest in bank stocks which makes your commentary completely irresponsible. Can't all stocks go to zero? So how does it make it safer if a stock trades for a penny a share vs a hundred?

    Buffet only acts when his margin of saftey is exceptionally high, which in the Goldman deal is evidenced. You should be ashamed if anybody acts on your writings and buys a single share of financial companies as anything other than a complete and total speculative shot in the dark. The Fool I started reading back in '98 was a very different place than it is now. What can't the Gardner brothers see this and be better than allowing such utter garbage exist on it's site?

    Could it be that it helps sell subscriptions? They're about to to lose four of mine!

    Mike

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