Time To Buy Banks? Proceed With Caution.

On Wednesday, July 16, 2008 before the market opened, Wells Fargo (NYSE: WFC) announced financial results that helped propel some huge stock market gains over the next two days. Also fueling the rally was JP Morgan Chase (NYSE: JPM) beating expectations and seeing oil decline by more than $15 from its recent highs. Wells Fargo did report weaker financial results compared to the prior year, but surprised the Street by not only beating expectations but also raising their dividend by 10%. The market reacted positively and WFC has since rallied 30% since hitting its 52-week low on Tuesday.

WFC has experienced write-downs, but has remained relatively healthy from a financial standpoint when compared to its peers. That is, WFC has remained solved, and even with lower earnings and a higher dividend when compared to last year, their payout ratio is well less than 100%, unlike some of their peers, such as Bank of America (NYSE: BAC).

The big two-day rally saw nearly every bank and financial services from all walks of life rebound exceptionally strong. Furthermore, SEC comments about better cracking down on naked short selling seemed to scare some of the shorts that were crushing these stocks into the ground. Everyone has been talking about how beat up the banks and financials are and when others are fearful, it is often time to get greedy. So, with the events transpiring, is this a definitive signal to buy in?

Before jumping ears deep into the banking and financial sector, we should take a little breather and evaluate the action the past couple of days. Nearly every bank and financial services company rallied, even the ones that are reportedly facing some serious challenges. Note Corus Bankshares (NASDAQ: CORS), National City (NYSE: NCC), and Lehman Brothers (NYSE: LEH) – each of these three companies have been identified to be in somewhat critical condition, and some say on their deathbeds.

However, the market ignored the fundamentals surrounding these three companies and their stocks rallied upwards of 30%-40% each. BAC has rallied more than 40% from its lows just a couple of days ago and now looks comically expensive with a dividend yield of 9.6% versus the 13.6% 72 hours ago.

Fundamentally, WFC and JPM still reported increased reserves for credit losses and write-downs and saw smaller earnings this year than they did the year before. UBS even came out and downgraded WFC after their 30% run up as the impacts of a weak economy and more credit losses potentially remain.

Some are arguing that the naked short selling will be a thing of the past after the SEC’s comments on the matter. However, the practice has been illegal for some time and enforcement has been non-existent. It is a great statement and well-intended, but until there is definitive proof of this practice and a formal investigation or indictment, the practice will likely continue.

I do believe that the current environment presents great buying opportunities for a select handful of banks that are best able to weather the storm. We may have seen the very bottom (although some say there is more downside than currently priced into the market), but I do not think we have seen a trend reversal. The reality is that many large and small banks have had to raise capital, dilute shareholders, cut and/or cease dividends, record write-downs, and increase loss reserves. Even with these tasks crossed off the to-do list, the banks are still facing a weaker economy and an environment where further interest rate cuts do not seem likely.

The past two days have been exciting from a bank stock standpoint, but even with the big 30%+ gains seen across the board, most of the names are still 25%-50% (or more) off from their 52-week highs. That is, there is still a long way to go until these banks reclaim their former glory and we can safely assume that many will not reach their previous highs for the foreseeable future. Even the banks that have gotten some positive news need to be reviewed with caution. For example, take Seacoast Banking Corporation of Florida (NASDAQ: SBCF), a bank that is on my accumulation list, was upgraded on July 9 by Sterne Agee. I wonder if they would re-iterate their opinion now that the stock has climbed 25% since the recommendation.

The market tends to overreact – and that goes in both directions. During the short term, it is easy now to say that the banks were oversold. But, as of today’s close, are they overbought? Finding and investing the best banks at these levels present some golden opportunities for potential long-term gains and fat dividends while you wait, but even with the positive news floating out in the marketplace, I do not think we are ready to see the shorts cover their positions quite yet.

If you were looking for good news on the banks, the past two days provided that. WFC reported and did not go out of business. In many ways, it seems the market was thinking that every bank would fall victim to the current crisis and collapse and leave our country bankless. I think the lesson we have seen is that some banks can weather the storm and stay out of serious trouble while we digest the credit crisis and the weaker economic environment.

If you have some intestinal fortitude and a knack for evaluating the liquidity of banks, you will likely find some great long-term values at these levels – but only after a little breather.

Disclosure: Author is long SBCF, no positions in other stocks mentioned

Comments

[goatfarmer:]

No sign of a bottom yet for the banking sector. Some foreign banks have just broken out of big tops: WBK, BBV, AXA (insurance).

2008 Jul 18 07:26 AM

[Ames Tiedeman:]

We have seen a huge rally in some of the bank shares. BAC and WFC particularly. Now C comes out this morning and their loss is less than expected. On top of this the SEC forbids shorting in a number of financial and bank issues. Further, a number of smaller mid-western banks have come out this week with earnings than beat. All of this spells a floor. The best way to invest in the financials is with an ETF like UYG.

2008 Jul 18 07:34 AM

[Tom B:]

Why do you say BAC looks expensive? What do you think of JPM?

2008 Jul 18 09:09 AM

[User 228195:]

I read somewhere that JPM has a 411.6% (as of July) credit exposure to Derivatives. 411% of what? What are Derivatives? Whatever the hell it is, it doesn't sound good - especially when the total debt accrued by "derivatives" in this country is 164 TRILLION dollars. This debt is handled mostly by 5 or 6 banks and JP Morgan is one of them. I don't understand what that is - will someone please explain? Email me!
[e-mail]

2008 Jul 18 10:28 AM

[Kunst:]

"WFC has remained solved"-- ? Did you mean solvent?

2008 Jul 18 12:23 PM

[Chemist29:]

Not to point out the obvious or anything, but you buy things when they are lower, not when they are higher, so you get more shares for the same cost. Example, the news was TERRIBLE tuesday morning, USB is still earning its dividend, so I bought, at 22.1 and locked ina 7.7% yield. Now i'm up 30% on principle also. Obviously not all my picks have done that but you buy on weakness, when things are low. When the good goes down with the bad, thats when to buy. By the time everyone starts feeling good and cnbc says buy banks, theyll already be up 30%.

2008 Jul 18 06:42 PM

[Chemist29:]

Maybe this represents climbing out of the bottom, maybe not. Who knows if we'll test these lows again but it honestly doesn't matter, next time it dips, buy. it's really that simple, enjoy the rally for now!

2008 Jul 18 06:46 PM