It's been a trying year for the Dow Jones Industrial Average (INDEX: ^DJI).
It began the year at approximately 12,200, peaked in May at nearly 13,300, plummeted to around 12,100 at the beginning of this month, and has since mounted a re-ascent. The index now stands at nearly 12,630, or approximately 3.4% higher than where it started the year.
Given this erratic behavior, you'd be forgiven for being wary of the market in general and the Dow more specifically. At the same time, however, avoiding these swings may come at a cost, as the index's best-performing stock year-to-date has posted monster returns.
The Dow's top stock
Bank of America (NYSE: BAC) has recorded a ridiculous 42% increase in its share price, going from $5.56 a share at the beginning of the year to nearly $8 today.
There are a number of explanations for this. First, the financial sector overall has performed well. For the year, the Financial Select Sector SPDR (NYSE: XLF), an exchange-traded fund that tracks the S&P Financial Select Sector Index, is up well over 9%. This is due in large part to strong performances by Wells Fargo, Berkshire Hathaway, and B of A itself, which are three of the fund's largest holdings.
Second, shares in B-of-A are still trading at a massive discount relative to their pre-crisis level. Prior to the financial collapse, B-of-A stock traded between $45 and $55 per share. Today, as noted above, they remain depressed by nearly 90%.
Captive upside potential?
While there are a number of ways you could interpret the latter explanation, one is that there's significant upside potential being held captive by our current economic woes.
My Foolish colleague Matt Koppenheffer convincingly made this point in a column two weeks ago. After looking at the valuation of the country's largest banks, via the price-to-book ratio, Matt came away with the clear impression that the financial industry will outperform the broader market, rating a large swath of banks as such in his Motley Fool CAPS portfolio.
The math is pretty simple. Prior to the crisis, in 2006, B of A traded for 1.8 times its book value. Today, it trades for 0.4 times book. In terms of valuation, the runner-up is Citigroup (NYSE: C), which trades for an almost equally attractive 0.5 times book value. To assume that B of A's massive discount is warranted, as Matt notes, is to effectively assume that the nation's second-largest bank by assets will implode and fade into nonexistence.
As a shareholder in B of A myself, I obviously don't believe this will happen. Quite simply, the financial chaos that would likely accompany the shuttering of B of A's teller windows would be unprecedented. Fellow Fool Morgan Housel provided a glimpse into what this may resemble in an article about the hypothetical collapse of JPMorgan Chase (NYSE: JPM) -- which according to reports today, may have lost as much as $9 billion in the London whale scandal.
It's one thing for the Federal Deposit and Insurance Company to step in and shut down, say, a $500 million community bank, which it's done on numerous occasions since 2008. It's a whole other thing to say it has the means and ability to do the same to a bank with a balance sheet rivaled in size by only JPMorgan, the largest U.S. bank by assets, and the Federal Reserve -- each of which controls over $2 trillion in assets.
I also believe that the likelihood of the big banks being broken up, as some have intimated, is highly improbable. At least for the time being, since passage of the Gramm Leach Bliley Act of 1999, the marriage between commercial and investment banks is a fait accompli.
Even if this were to happen, moreover, it wouldn't necessarily be a bad thing for bank shareholders if a fracture would release otherwise captive value. Morgan noted yesterday that it's been estimated that JPMorgan would be worth one-third more if broken up. And this could be more extreme in B of A's case: Who's to say what B of A would be worth without the $40 billion albatross that is Countrywide hanging around its neck? My guess is a whole lot more.
It's still not too late
Take my opinion for what it is, as I am a B of A shareholder. Despite its already stellar performance thus far this year, I believe B of A (and the other big banks mentioned above) still provides buying opportunities. Our top analysts expand on why this is so in our latest free report: "The Stocks Only the Smartest Investors Are Buying." The report even discloses a smaller financial institution that Warren Buffett would have coveted in his early years. To learn the identity of this stock, and to read more about the promising opportunities in the financial sector, click here now -- the report is free.
