Zombie Bank Stocks That May Murder Your Portfolio

by Ivan Martchev | April 26, 2011 1:14 pm

By now everyone knows that the Western financial system got us into trouble in 2007 and 2008 with imprudent lending practices, exotic structured products and too much leverage. This created huge losses for investors in emerging markets — despite the sound fundamentals of the emerging market economies.

So you can see why it is important for investors interested in the East to nonetheless keep a close eye on developments in the West.

Currently, we’re again seeing weakness in the Western banking system. And when the Western banking system is not healthy, developed economies are not healthy.

This is because major losses deplete banks’ capital, leaving them unable to act as healthy facilitators of the credit intermediation process that makes the economy tick. When the credit multiplier in a banking system does not work, nothing works properly in a finance-based economy like the United States. This is why we have unprecedented involvement of the Federal Reserve in the capital markets[1] right now, trying to fill that void of credit.

History will judge if the unorthodoxy of QE1 and QE2 will be a success, but I am of the opinion that the verdict will not be kind[2]. I believe that the last thing an over-indebted system needs is more debt and central bank monetization.

It looks to me that the administration and the Fed have bought time, but I have great difficulty seeing what they have bought time for — the dearth of any meaningful structural reforms is glaringly obvious.

With short-term interest rates near zero and long-term interest rates positive, the banks should be minting money by borrowing short and lending long. And they have reported the necessary stabilization of their financial performance judging by their recent quarterly performance. So why are the stocks of major U.S. financials making fresh 52-week lows, relative to the all-important S&P 500 index?

XLF vs. SPY Chart

While the financial sector made its relative high in outperformance against the S&P 500 in the fall of 2009, things have gotten much worse on a relative basis since then. I can’t recommend owning a single large western financial stock in a long-term portfolio based on the realization that piling on more debt on top of an unsustainable debt burden at the consumer and government level will only cause more losses in the future.

Recent financial performance shows that banks are scared to lend as they saw the biggest percentage drop in quarterly revenue in three years. Bloomberg calculated that net revenue at the six lenders — Bank of America (NYSE: BAC[3]), JPMorgan Chase (NYSE: JPM[4]), Citigroup (NYSE: C[5]), Wells Fargo (NYSE: WFC), Goldman Sachs (NYSE: GS[6]) and Morgan Stanley (NYSE: MS[7]) — fell 13.3% in the first quarter from a year earlier. (Goldman and Morgan were forced to be reclassified as banks but are de facto securities firms). Pretax pre-provision profits, which exclude taxes, loan-loss provisions and one-time items, and are considered a better gauge of profitability than earnings, slid a whopping 40.2%.

There is another aspect to the performance of GS and MS that is different than the broader financial sector. Since their businesses are geared toward capital markets much more so than any of the larger banks, they act as canaries in the coal mine for the overall health of the stock market[8]. They both bottomed in the fourth quarter of 2008, way in advance of the overall stock market and financial sector. And now they may have topped way in advance in the fourth quarter of 2009, as their stock market performance has deteriorated notably since.

I don’t know if the end of QE2 in June will mark the top in the U.S. stock market — provided QE3 is not coming, of course — but if I was a large shareholder of any of these financials I would consider liquidating the positions. The bear market rally in those stocks is likely over.

While some financial companies from key emerging markets have seen large corrections[9] due to relentless monetary tightening[10] by their respective central banks, they have much better long-term fundamental outlooks and provide opportunities to buy the dips as they operate in healthy banking systems.

As for the major U.S. bank stocks, I recommend that you sell the rally.

  1. unprecedented involvement of the Federal Reserve in the capital markets: https://investorplace.com/38444/feds-monetary-malfeasance-creating-catastrophic-bubble/
  2. verdict will not be kind: https://investorplace.com/38524/fed-press-conference-ben-bernanke-qe2-inflation/
  3. BAC: http://studio-5.financialcontent.com/investplace/quote?Symbol=BAC
  4. JPM: http://studio-5.financialcontent.com/investplace/quote?Symbol=JPM
  5. C: http://studio-5.financialcontent.com/investplace/quote?Symbol=C
  6. GS: http://studio-5.financialcontent.com/investplace/quote?Symbol=GS
  7. MS: http://studio-5.financialcontent.com/investplace/quote?Symbol=MS
  8. canaries in the coal mine for the overall health of the stock market: http://asia.investorplace.com/asia-insider/archive/global_investing_100914-part2.html
  9. large corrections: https://investorplace.com/37248/china-stocks-to-buy-lfc-cric-ej/
  10. monetary tightening: https://investorplace.com/35595/emerging-market-stocks-to-buy-infy-hdb-ibn-ttm-scif/

Source URL: https://investorplace.com/2011/04/bank-stocks-to-sell-bac-c-gs-ms-jpm-wfc/
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