The Upside And Downside Of Betting On Financials

Includes: BAC, BLK, C, CS, DB, GS, JPM, MS, WFC
by: Benjamin Goldman

I've heard a lot of talk recently about how financial stocks have been "bottoming out" and now is the time to buy. From the debates I've participated in and read through, there are two sides: those who believe that the financial sector is due for a rebound and those who believe that the financial sector has entered a new age where banks can't generate consistent positive earnings and the bearish financials market is here to stay. I have been bullish on financials for over a month now and up until last week, I was being proven wrong by the market. However, the end of last week told a different story. In just three days (the close of November 29, to the close of December 2), Citi (NYSE:C) and Bank of America (NYSE:BAC) stocks increased by over 11 percent each while Credit Suisse (NYSE:CS) and Goldman Sachs (NYSE:GS) shares increased by over 9.5 percent. In this article, I give my view on what's going on in financials.

The Upside

As Warren Buffett has mentioned recently, stocks are on sale. Stocks are trading at low multiples as if we are in a recession when in reality we are not. If there are to be no radical changes in the financial sector over the next few years, financial stocks are very cheap. The crisis in Europe, recent struggles and Bank of America, and the bankruptcy of MF Global (OTC:MFGLQ) are all priced into every stock on the market and financial sector stocks are the most affected. For those who believe that these issues will be resolved and no major financial institutions are in major trouble, now is definitely the time to buy. Investors like John Paulson made huge returns when going long on financials in early 2009, and this may be a second chance for investors to do the same.

The Downside

Stocks go down for a reason. Stocks have been having a bearish run because of the POSSIBILITY of crisis. If a crisis like a major sovereign debt default or a European depression ends up happening, stocks will fall much more. If consumers begin trusting non-profit credit unions over banks, that could potentially drive a Wells Fargo (NYSE:WFC) or JP Morgan (NYSE:JPM) into bankruptcy. Although these are pretty big "ifs", there are a lot of "ifs" looming in the current market and any one of them happening will drive down prices further.

My Recommendations

As Jim Cramer has said "there are broken stocks and there are broken companies." Broken stocks are underpriced because of what is happening in the current market, but the company itself is still doing well. Broken companies no longer have successful business models and are doomed to fail. The gist of what Cramer's saying is that buying broken stocks will net you a nice return while buying broken companies will ruin your investments.

One of my favorite financial institution stocks is BlackRock (NYSE:BLK). The company has consistent earnings growth and generates its revenue from client business and not the market. Despite having little exposure to the crises affecting the market, its price fluctuates like it is a bank stock. BlackRock is an example of a broken stock and over the past 3 months, it has outperformed the market with over 8 percent stock price growth, while almost all American financial institutions have dropped in stock price.

American International Group (NYSE:AIG) was an example of a broken company. It had a very strong exposure to the housing market and was essentially doomed for bankruptcy if housing prices were to ever go down. Anyone who held on to the stock during the housing crisis lost almost everything and many of those people held on to shares with a similar thought to today's bullish investors: "how much more can this go down".

European banks like Deutche Bank (NYSE:DB) and Credit Suisse are still on the fence with whether they are broken stocks or broken companies. Their share prices have each plummeted in the last 6 months, Deutche Bank by 32 percent and Credit Suisse by 42 percent, and they both have a lot of exposure to the European debt crisis. Betting on them is essentially betting on the European debt crisis. If the crisis is solved, these will appear to have been broken stocks, but if crisis ensues, these will become broken companies. I believe that holding either stock is extremely risky and should only be done by those who feel extremely confident with how the crisis will end.

In a nutshell, I believe that banking stocks will recover, but to levels below 2010 prices, similarly with what happened in 2008 and 2009. There are major threats in the market and many of them will linger for several years. Just look at how Bank of America is still dealing with mortgage issues. Financial instution stocks are not safe bets by any means and there are plenty of blue chips out there that are much safer value buys. However, for those who like to gamble, now is an excellent time to place your bets.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.