The 3 Biggest Reasons To Stay Out Of Bank Stocks

Includes: AIG, BAC, C, GS, JPM, MS, WFC
by: Bio Insights

It may be tempting, to a degree, to step into long positions on the banks now that Greece's debt has been "contained" for the most part. The Eurozone debt crisis seems to be cooling off, and sentiment is rebounding. One can also see that the big banks have all declined significantly in value from the start of the year, creating a potential buying opportunity based on perceptions of intrinsic value.

This might get buy-and-hold investors excited, but I think many are overlooking one of the biggest value traps on the market. It's true that banks are trading below what used to be intrinsic value, but there are good reasons for it. Here are the three big ones that stick out the most:

1) The banks are losing their profitability

The most fundamental reason to invest in a company is because you believe in its business model, and you think that it will generate enough cash such that it will eventually be returned to you (the shareholder). Banks have a variety of ways to make money, but their fundamental business naturally relies heavily on loan markets. Despite fed intervention to weaken the dollar through quantitative easing, the dollar has gained much of what it has lost. This has undoubtedly caused major damage to bank assets through deflationary pressure, some of which we have yet to see.

Consider that JP Morgan Chase (NYSE:JPM), generally considered "the best in breed" of the big banks, has had negative earnings growth between Q3 2010 and Q3 2011. It's true that most of the net losses probably came from the huge mistakes the banks made at the trading desks leading up to the summer crash, but there are other factors that point to lower earnings in the future. For instance, CEO Jamie Dimon made statements reflecting the weakness in the investment banking sector by issuing plans to reduce staffing. On top of that, JPM, which boasts the highest investment banking fees on Wall Street, intends to slash them in the near future due to the increasing competition and lack of clients. This is not a healthy sign for what has been one of the most profitable and lucrative businesses on Wall Street.

You can also look at Wells Fargo (NYSE:WFC), a Warren Buffett stock, which trades at a seemingly inexpensive P/E ratio of 9.4. Their Q3 report may have had record earnings, but there is reason to believe that the trend is unsustainable. Not only have net revenues declined since Q3 2010, but the bank's total pool of loans has shrunk as well. The record profits are coming from efficiency measures that the bank is undertaking, which you can see in an increase in the bank's profitability ratio relative to last year (1.26% this year relative to 1.09% last year). While this particular statistic should be a positive sign, the fact that the bank is only making record profits because it is dumping employees and being stingy with its operational expenses makes the solid EPS numbers truly meaningless in the long run.

2) Public opinion is strongly against them

Regardless of your own opinions on the matter, it seems that the public depiction of bankers as crooks has never been more apparent. With the Occupy Wall Street movement spreading around the globe, and the huge popularity behind the 99% movement, one can infer that financial institutions are stuck in the PR frying pan.

While protests and speeches don't actually harm the banks by themselves, things like the Facebook group entitled "Bank Transfer Day" can. This is a new development in the Occupy Wall Street movement which encourages people to switch to credit unions in order to help crumble the corruption of Wall Street. It's estimated that 650,000 Americans have already switched to credit unions since late September, and the exodus doesn't show any signs of slowdown.

According to this article published by Bloomberg, Harris Interactive estimated that a whopping 9% of Bank of America (NYSE:BAC) customers said that they fully intended to leave the bank due to dissatisfaction and out of protest. The last thing this troubled bank needs is to lose customer accounts in times like this. Not to mention, this is happening after BAC withdrew plans to instate its extremely unpopular $5 monthly debit card fees. Just last week, CEO Brian Moynihan announced that the bank would enrage shareholders instead through a share dilution to the tune of 400 million. I'm not sure why he was allowed to make the claim that the bank had no need to raise additional capital earlier in the year, but it's now apparent that he was lying. Who knows what other false claims have been made. We can't forget the hidden $10 billion dollar loss to AIG a few months ago either, or the massive 40,000 person layoff plan the bank implemented to save money.

Does anyone remember the statement made by Citigroup (NYSE:C) CEO Vikram Pandit earlier in the year, where he stated that he fully intended to make Citigroup worth at least $10/share? Well, at the time shares were trading at roughly $4.50/share, and after a reverse 10 to 1 stock split it seems that he made good on his promise after all. I suppose that due to the stigma associated with stocks trading under $5/share, it was a good move for the bank, but the fact that Citigroup thought that the shares wouldn't be able to rise above that level is downright depressing. If the reverse split hadn't happened, those shares would be worth about $3/share now. Now that's a low number.

In addition to the populist momentum working against the banks, the government may not be done either. With increasing volatility and uncertainty in the financial markets over Europe, and the recent bankruptcy of MF Global to fan the flames, it seems that the government will not be loosening its grip on Wall Street for quite some time. Allowing financial institutions to gamble with 40:1 leverage on extremely risky assets like European sovereign fixed-income instruments, with other people's money, is quite insane.

Contrarianism (going against the trend) only works when a company's fundamentals are fine despite bearish hype on a stock. Sure, these financial institutions are extremely hated universally, but tangible damage is being done to these banks on a daily basis.

3) There will be plenty more "surprises" on the balance sheets

While the Greek crisis seems to have a pretty good fix for the time being (if it holds), there is reason to believe that it won't be as easy next time. Not only has the political willpower for bailouts been drained from the populace of solvent nations like Germany, where the majority of the people opposed the bailouts to begin with, but the question of where all the money is coming from remains to be solved. Are we going to pin all our hopes on China's generosity?

Italy, which is probably going to be the next "Greece", is a much larger economy. I originally figured that the big banks' estimated $33 billion exposure to Greece was an example of why banks weren't going to suffer truly catastrophic damage from Europe, but if MF Global has taught us anything it's that leverage swings both ways. In addition, credit default swaps make things impossibly complicated. Not only is Italy an enormous bond market relative to Greece, but shareholders of the big banks and more specialized firms like Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) won't have a clear picture of what's going on at the trading desks since full disclosure of the risks is never entirely possible.

In addition to the potential of hidden disasters on their balance sheets, the banks have been losing big at those same trading desks. The details are fuzzy, as always, but looking at the latest round of quarterly reports one can see sizable losses in institutional asset management. Of course, third party asset management has done well since the banks get paid even if they lose their clients' money.

There's no way to truly know how bad things could get if any of the other PIIGS default, but if you're crazy enough to buy shares of the big financial institutions of Wall Street nowadays you can be assured that there is great potential for "surprises" down the road. The reward, relative to the risks one must take in holding bank stocks, is simply not worth it at this time. Sure, there is the chance that you might beat the market by a few percentage points a few weeks later, but you're risking direct exposure to potential Lehman-like events.

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