These Stocks Are in Dead Water

The Federal Deposit Insurance Corp. released its quarterly banking profile this week, and the data show that two of the trends affecting the country's largest banks continue to play out, one bullish, the other bearish. Let's start with the good news (for the banks and their shareholders, not for taxpayers):

The big get bigger
Back in December 2009, I made three 10-year predictions for the banking industry, including this one:

At the end of the third quarter, the top four U.S. banks -- Bank of America, JPMorgan Chase (NYSE: JPM  ) , Citigroup (NYSE: C  ) , and Wells Fargo (NYSE: WFC  ) -- had combined assets of $7.4 trillion, which is equivalent to over half the GDP. In 2020, I expect the top 10 banks' share of total banking assets and total deposits to be equal to or higher than today's levels.

It was partially on the grounds of that dominant market share that I suggested a basket trade consisting of those four banks in November 2010, to which I added US Bancorp (NYSE: USB  ) in April (to track this basket using My Watchlist, click here). If we compare this group against the entire sector, the trend toward increased concentration appears to be chugging along:


Q1 2011

Q4 2010

Q4 2009

Q1 2006

Top 5 Banks -- Total Assets $8.0 trillion $7.9 trillion $7.6 trillion $4.9 trillion
As a % of All FDIC-Insured Institutions 59.5% 59.0% 58.4% 44.0%
Top 5 Banks -- Total Deposits $3.9 trillion $3.8 trillion $3.7 trillion $2.3 trillion
As a % of All FDIC-Insured Institutions 40.9% 40.7% 40.9% 31.8%

Sources: Capital IQ, a division of Standard & Poor's, and FDIC.

An unsustainable source of profit growth
Increasing market share is a positive headwind for the basket trade, but the FDIC's report highlights a downside risk as well. The industry's profit growth during the first quarter was the product of decreasing reserves rather than loan growth, which can't be repeated indefinitely (i.e., actual loan losses came in lower than reserves so that part of the reserves are "released," which boosts profits). Decreasing reserves and revenue -- both were concentrated within the largest banks.

Waiting for loan growth
This could be a "show me" situation, in which the market will want to see sustained, positive loan growth before it revalues the shares. That growth depends on the strength of the economic recovery -- sure enough, the basket has performed miserably over the past month, just as growth prospects have dimmed. I continue to think this basket will ultimately produce excellent returns -- on a relative and an absolute basis -- but investors will need to be patient to capture them, as it could take 12-24 months for the trade to work out.

These banks may be "too big to fail," but we've got "Too Small To Fail – 2 Small-Caps the Government Won't Let Go Broke."

Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of Wells Fargo and JPMorgan Chase. The Fool owns shares of and has opened a short position on Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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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 May 26, 2011, at 12:15 PM, buffalonate wrote:

    I have been buying up a lot of the larger banks in the last week. The American Bankers Association says that loan defaults are down across all 8 categories. The tier 1 capital ratios are up for the large banks recently. These two things in conjunction with many large banks at 3 month lows makes me feel comfortable to buy in. My favorite bank by far is First Niagara Financial Group. It remained profitable during the financial crisis and has doubled bank branches in the last couple of years due to acquisitions. It also has a 4.6% dividend yield.

  • Report this Comment On May 26, 2011, at 5:48 PM, bk2nrml wrote:

    im avoiding all bank stocks. the concern i have is financial repression.....

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