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Is it time to buy the UK banks?

BY THEO CASEY

You’ve probably seen these ads in your inbox in the past few weeks:

“LLOYDS / RBS – Is it time to buy the shares right now?” – or similar headlines...

It’s very tempting. After all, the UK banks with government support –Lloyds and RBS – are trading at less than half of their pre-credit crunch values. Should those prices recover, you could make a fortune. Plus, in the words of Alistair Darling (among many others), the worst of the economic downturn is now behind us.

Not to mention the ‘X factor’ – the cost of being a bank has never been so low. So should you take the plunge? Let’s have a look...

As we discussed in May, inter-bank interest rates, as measured by LIBOR, are at all-time lows
. Consider the traditional business model of a bank – borrowing money at one rate and lending it at another. The disparity between these two rates has never been greater. As long as the banks continue to not pass on the savings to their customers, profitability will be huge.

However, despite these various opportunities, now is not the time to buy.

In fact, it might already be time to sell the banks…

The inconvenient truth behind the bank rally

Before getting too excited about the banking “recovery,” we must remember that no one in their right mind was actually buying them, in the true sense of the word. We were all too fearful:

Institutional investors, chastened by the severity of the credit crunch and the havoc it wrought on their funds, were not buying. Neither, it seems, were high-net worth individuals (rich people), according to a recent report by Barclays Wealth.

So what was behind the bank rallies?

The surprising answer is that it was short sellers. What short sellers do is sell high and buy back low. They spot an overvalued or fundamentally weak stock that could fall in price. Then they borrow some shares from a brokerage firm or pension fund and sell them. If the price drops, they then buy back the shares, return them to the lender and pocket the difference as profit.

The reason that fundamentally weak stocks, i.e. banks, were rising was not because normal investors saw an opportunity to profit by buying. Rather it was because short sellers “covered their shorts.” This is where short sellers buy back the stocks they had previously short sold. They were closing out their positions to take their profits.

That’s what I mean when I say that investors were not buying banks in the true sense of the word. In effect, these were “artificial” rallies in banking shares. And this puts the optimistic “green shoots” narrative in its place. It was – and still is – false.

And we must also consider the regulatory troubles ahead... Lord Turner of the FSA is threatening to impose rules tightening the “capital adequacy” requirements. This means banks must keep more of their money in the bank rather than lending it out. Such forced prudence would mean banks would be, at least in the short term, less profitable.

With this potentially game-changing legislation coming in the near future, it would not be sensible to invest in the banks that are in the regulator’s crosshairs right now. If you’re one of the few that is already invested and that has benefitted from the bank boom in March and April, now might be a good time to take some profits as the downside risk is at least as big as the upside potential.

Stay out of risky trades in the summer of surprises

We face a summer of surprises and the bank sector won’t be a good place to hide…

I hate to always be the bearer of bad news, but this is not a good time to invest 100% of your wealth in stocks. For my own subscription service, I’ve picked out my three favourite holdings and only one of them is a stock.

It’s going to be a tough stretch, as we’re already finding…

The FTSE 100 posted its first down month since March. If future falls from this point are as even-tempered as we saw in June, we investors should count ourselves lucky. We should prepare ourselves for the possibility of a 2008 style market correction as the green shoots turn to brown weeds.

If you want to buy stocks, you should look at the more defensive end of the market. Sell out of the riskier positions – i.e. banks – and into more robust, and significantly cheaper, and higher yield blue chips.

Defensive plays like AstraZeneca and Unilever look particularly cheap right now.

UK banks like RBS and Lloyds do not.

Best wishes,

Theo Casey
For The Right Side

Editor’s note: Theo Casey is the investment director of The Fleet Street Letter, the UK’s longest-standing investment newsletter. The team’s latest research advises readers where to put their money now to best survive and profit from the “summer of surprises”. This includes three timely files:

  1. The Best Investment for the Next Six Years;


  2. Gold: The best way into the "Ultimate Inflation Haven";


  3. Three "Price Makers" that could make you rich in the inflationary years ahead. [NOTE: These are shares in defensive sectors that offer good value at current levels.]

Click here to access this time-sensitive advice now.

Note: Your capital is at risk when you invest in shares; never risk more than you can afford to lose. Please seek independent financial advice if necessary.

Disclosure: No positions