Bank Stocks: Are They Cheap Because They Are Bargains Or Value Traps?

The Financial Select Sector SPDR ETF (NYSEARCA: XLF), a benchmark exchange-traded fund that tracks financial stocks in the S&P 500 (INDEXSP: .INX), is about 60 percent below its all-time high, reached in October 2007, leaving plenty of room for potential gains. By contrast, the S&P 500 has recouped much of its loss since the worst days of the financial crisis, lagging its high five years ago by only about 8 percent.

Moreover, U.S. banks had excellent first-quarter earnings -- with 80 percent of the 165 banks covered by financial-analysis firm Keefe, Bruyette & Woods Inc. beating or meeting expectations.

In most instances, all of this would foreshadow a lot of smart money moving into financial-services stocks. But, in fact, the converse is occurring: A steady stream of analysts and investors are questioning the sustainability of the strong showing of bank shares and whether banks are, in fact, overvalued.

Financial companies have an uncommon ability to go bad really fast, said Mark Coffelt, chief investment officer of Empiric Advisors Inc. and portfolio manager of the Empiric Core Equity Fund in Austin, Texas. When you are investing in a bank, you are actually investing in a leveraged, blind investment portfolio, and the investment portfolio is invested by bankers. It's just very hard to have an accurate value because they hold so many assets, and the assets they hold are not always clear.

Of particular concern are the largest U.S. banks -- the too-big-to-fail crowd such as JPMorgan Chase & Co. (NYSE: JPM), Bank of America Corp. (NYSE: BAC), Citigroup Inc. (NYSE: C), Wells Fargo & Co. (NYSE: WFC), Goldman Sachs Group Inc. (NYSE: GS), and Morgan Stanley (NYSE: MS), all of which took money from the U.S. government during the 2008 financial-sector bailouts.

The problem is that the [banking] sector's numbers are driven by the big money-center banks, and the big money-center banks haven't gotten through all their problems yet, said Gary Gibbons, academic director of the Thunderbird Private Equity Center in Glendale, Ariz., and a portfolio manager. They still have lots of European sovereign debt outstanding and then couple that with the fact that most of them have some kind of baggage coming out of TARP [Troubled Asset Relief Program], out of the restructuring that occurred in 2008 and 2009.

A case in point is the unexpected debacle at JPMorgan Chase this week. After coming through the financial crisis better than most of its peers, the company revealed Thursday that it faces at least a $2 billion trading loss from bad European investments made out of a previously little-known corner of the bank's vast operations.

JPMorgan Chase Chairman and CEO Jamie Dimon, a Wall Street hero for his candor and no-nonsense approach to management and company performance, blamed errors, sloppiness, and bad judgment for the losses as he warned it could get worse, as much as $1 billion worse. As of Friday's closing bell, JPMorgan Chase's shares had shed about one-half of the 23 percent they had gained so far this year.

Pick Your Battle

Still, it is hard not to be enticed to at least take a flier on big banks whose shares are selling at or below their book value (the total value of a company's assets that shareholders would theoretically receive upon its liquidation). Among them is Citigroup, which sells for 0.50 percent of its book value.

Yet, a cheap stock usually has a reason for being inexpensive, experts warned.

What happens if the value of the debt [on its balance sheet] drops? asked Michael Farr, president of portfolio-management firm Farr, Miller & Washington in Washington. In the investment premise, we call it a 'value trap,' meaning something that's cheap may just become cheaper.

Perhaps the biggest concern is bank earnings. Although these reports have been comparatively strong, many analysts simply do not trust the integrity of the numbers.

Douglas Hendee, vice president of financial-services firm Brighton Securities in Rochester, N.Y., said that big banks' earnings announcements involve an awful a lot of accounting gimmickries and not much that would lead him to believe that there is healthy organic growth.

I'm not inclined to buy the common stocks of any of the banks that were involved in some of the very difficult circumstances with respect to mortgage-backed securities, CDOs [collateralized debt obligations], back in 2008, said Hendee. Fool me once, shame on you, but fool me twice, then shame on me.

Hendee said that investment banks should be generating revenue from engaging in activities such as issuing bonds or equities. Yet, most of these banks are driving their earnings by moving money from column A to column B -- that is, taking money that they have set aside for loan-loss reserves and putting it back on their balance sheet.

For example, in the first quarter of this year, JPMorgan Chase reported earnings of $5.38 billion, a bit below earnings of $5.56 billion in the same period a year ago. But the most recent result reflects a $1.8 billion boost to the bottom line from reductions in its mortgage and credit-card loan-loss reserves.

While the big banks are certainly suspect, experts contended there could be some real gems for investors hidden in the financial-services sector, particularly in the smaller community banks that are focused more on U.S. markets and instruments and that are not overly exposed to potentially problematic European debt.

Among the more successful of the publicly traded community banks this year are The Bancorp Inc. (NASDAQ: TBBK) in Wilmington, Del. (whose shares are up 40.1 percent); Central Valley Community Bancorp (NASDAQ: CVCY) in Fresno, Calif. (up 28 percent); and Community Bancshares of Indiana Inc. (NASDAQ: CBIN) in New Albany, Ind. (up 39 percent).

Banks are exposed to banks, so there's no one who will escape altogether if the European debt crisis worsens, said John Carey, a fund manager who helps oversee about $220 billion at Pioneer Investments in Boston. But, for the most part, whether the regional banks will prosper or not depends on how our economy goes -- and our economy has been growing beneath all of this turmoil.

'Long, Hot Summer'

Perhaps the most telling indication that bank stocks are in for a rough ride is the increasingly pessimistic advice offered by Dick Bove, the widely followed vice president of equity research at Rochdale Securities in Stamford, Conn., who until recently had been one of the most bullish banking analysts.

In an April note, Bove cautioned investors about a long, hot summer when investors are likely to note continuous increases in bank earnings ... but no positive movement in bank stocks.

That said, Bove tells investors to maintain their holdings in bank shares and even purchase a few more.

While I continue to believe that it will be difficult to make money in bank stocks this summer, I think these stocks will outperform the markets in the fall, Bove said. Therefore, my recommendation is to hold on to the stocks, buy them in small amounts this summer, but do not expect to make a great deal of money.

Of course, that assumes that bank fundamentals are not as bad as many experts believe them to be when you peel back the covers -- a decidedly contrarian opinion. Much more prevalent is the conclusion that at least for now banks can't be trusted with your money.