Are Bank Stocks Getting Ahead of Themselves?

With bank stocks rising for over a week now, we have to wonder whether this rally has staying power.

Looking at the KBE Bank Index ETF (KBW), for example, it's hard to believe that it is up over 20% from its recent low, going from around $22 to $28. In contrast, the more broadly based Select Sector SPDR Financials ETF (XLF) is only up around 7%.

Three news items I saw yesterday put me in a cautious frame of mind.

First, it seems that the Fed's action to lower the discount rate has had the desired effect. The markets are calmer. The "flight-to-safety" bond rally is losing steam, even at the short end, as investors rotate back to equities. Nevertheless, the markets believe the Fed will further come to the rescue with a cut to its overnight funding rate by September 18 or sooner. As a result, investors are bidding up stocks across the financial spectrum. But why should the Fed cut? The discount rate cut seems to have achieved its objective. Cutting the Fed funds rate now could be construed as just saving Wall Street bonuses.

Second, the FDIC announced that bank earnings have fallen 3.4% in the second quarter. This was primarily due to mortgage defaults, increased reserves to cover loan losses, higher expense for non-current loans and lower investment returns. Though most banks remain in good financial shape, the FDIC says, some of these problems are hitting levels not seen
since the early 1990's. Keep in mind, though, there were no credit crunches in the second quarter, no hedge fund implosions, no stock market plunges. What might be in store for third quarter numbers given that we saw all those things happen within the last few weeks?

Third, the Wall Street Journal had an article yesterday indicating that banks are starting to tighten lending standards not only on mortgages but also on other kinds of loan products such as credit cards, auto loans and personal loans. This serves to enhance portfolio quality but slows portfolio growth and consumer lending profits. Though not all banks are tightening everywhere, it is becoming more common in those same areas where the rate of mortgage foreclosures is highest. Securitizing and selling loans will be more difficult also due to lower loan volume and skeptical credit markets, further squeezing profits.

To sum up, chances of a Fed rate cut are receding, bank earnings are weakening and lending standards are tightening. At the risk of going against the tape, it seems to me the opportunity for bottom fishing in the financials may not be here yet.

With the after-hours announcement Wednesday that Bank of America (BAC) is investing in Countrywide Financial (CFC) certain to cause another advance of stock prices in the financials, I feel like I am going out on a limb here. Still, I feel that caution should rule for now, not blind optimism.

Disclosure: Author owns no shares in the stocks or ETFs mentioned in this post