Bank Stocks May Crash and Burn After Hot October Run

BankIt’s no surprise that while the Dow Jones Industrial Average and S&P 500 rolled back on Monday, the financial sector led the declines — with JPMorgan Chase (NYSE:JPM) down over 5%, Bank of America (NYSE:BAC) off over 7%, Citigroup (NYSE:C) off almost 8% and Morgan Stanley (NYSE:MS) off almost 9% to start the week. After a red-hot run in October, financial stocks were looking overbought to just about everyone.

But the question going forward is whether this is just a pause for the sector amid a resurgence, or a sign that the gains are fleeting.

Unfortunately, it looks like the latter. Banks have lagged the market in 2011 and look to be taking a beating yet again.

Underperformance for Banks in 2011

A look at the stock market across the past six months shows a clear divergence between the broader market and the financial sector — as represented by this chart of the SPDR S&P 500 ETF (AMEX:SPY) and the Financial Select Sector SPDR ETF (AMEX:XLF).

S&P vs XLF
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Namely, during the May market weakness we saw financial stocks move sharply lower than peers in other industries — and when the mayhem in August struck the market, the same overreaction to the down days persisted in the sector.

Consider one case study on Aug. 4, when the Dow lost more than 500 points in a single day to slide about 4.3%, Bank of America gave up almost twice that — 7.5%. Citi dropped about 6.6%. The rest of the sector performed similarly to these laggards — and similarly to today’s performance, where financial stocks were hurt more than the rest of Wall Street on negativity.

That’s just one example in a long line of declines recently that outpaced the broader market’s stumbles. There is significant underperformance of the sector year to date as a result, with the XLF fund off about 15% compared to a flat S&P 500.

The rally in October indeed affected bank stocks more than other sectors — but don’t fool yourself into thinking the outperformance was dramatic. Since Oct. 3, when the mini bull market began, the XLF financial ETF is up almost 15% compared with a little less than 12% for the S&P 500. That’s not exactly a huge difference.

In short, on the whole financials take it on the chin MUCH harder than the rest of the market when times are tough, but only bounce back a bit faster than other stocks. Since protecting yourself from severe declines is equally important as outperformance on the way up — perhaps even more important considering the market seems intent on building a leg down after October’s leg up — those who are banking on the outperformance of banks could be in for trouble this November.

Especially if the overall trend of the broader market is down.

Poor Earnings, Poor Outlook

Even if you want to ignore the overall lag of the financial sector so far this year, it is very difficult to make a case for significant improvement in financials across the next several months.

After recent earnings from major financials, it has become clear that the “improvements” at financial stocks are outside of any improvements in core business operations or fundamentals. Revenue is flat. Lending is stagnant. Earnings are juiced by one-time sales — such as the China Construction Bank transaction for BofA that brought in $8.3 billion and a hefty profit — or accounting charges based on spreadsheet changes and not true growth in the bottom line.

Worst of all is the fundamental problem facing America’s economy as a whole. A poor job market and weak consumer confidence means fewer folks with the means or inclination to take out loans. Of those who want loans, stricter standards at banks demands more prospective borrowers get turned away. Throw in the laundry list of recently passed and proposed regulations — higher capital requirements, prohibitions on investment activities and so on — and you can see why so-called “core” lending operations are not growing at a very encouraging rate even though we are three years removed from the worst of the financial crisis.

Oh yeah, then there’s continued troubles with bad debt and lawsuits relating to the subprime mortgage crisis. Don’t forget about that, or the fact that an escalating inventory of bank-owned homes thanks to ever-increasing foreclosures continues to create a logistical nightmare for financial stocks. They never set out to be property owners, but that’s what the housing crisis has forced these lenders to become.

There are those who say that banks might be a bargain right now since uncertainty is high and investors still are averse to the sector. After all, when you buy in after the “all clear” sounds, you likely have missed most of the gains.

However, in the case of banking stocks, there remain very strong reasons to be skeptical of the recent run-up in shares and to expect the sector to continue to lag behind.

Jeff Reeves is the editor of Write him at, follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook. As of this writing, he did not own a position in any of the aforementioned stocks.

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