Why I Don’t Like the Bank Stocks

“Profit Confidential” Column, by Michael Lombardi, CFP, MBA.

Have you been watching Bank of America Corporation (NYSE/BAC) stock lately?

The last couple of weeks have been terrible for Bank of America stock. First, a rumor surfaced that the government would ask Bank of America to issue more stock to raise more capital. Then, a story surfaced on the Internet that the government, in its proposal to overhaul the banking system, would force large banks like Bank of America to downsize.

My theory on why the bank stocks have been faring poorly in recent weeks has nothing to with the government meddling with the banks’ capitalization or size. My negativity towards banks has to do with the real estate market and interest rates.

On Wednesday, I wrote in this column how I believe, “real estate is dead for years to come.” If we look at the loan books of any major bank, they are usually made up of consumer loans, business loans, real estate loans, and credit card loans. Real estate loans, by far, are usually the biggest portion of a bank’s loan book, or at least that portion which is secured (by the real estate itself).

I don’t believe the banks have done a full job of purging their “bad” real estate loans. There could be billions of dollars in “questionable” real estate loans still on the books of the banks as “good” loans, which should really have been transferred to the allowance for doubtful accounts (which would affect the profits of the banks).

If interest rates rise, which I surely believe they will, the strain on the real estate market will intensify. This concern is putting pressure on the bank stocks.

The stock market, as a leading indicator, is looking one year out and expecting interest rates to be higher one year from now than they are today. That’s an obvious occurrence in many countries. The question becomes: can residential mortgages and commercial mortgages be safe in a period of rising interest rates? My answer is no.

As interest rates start to rise in 2010, there will be further strain on property owners to make their rising monthly payments on their mortgages. And this will cause the banks pain. Hence, I do not believe that it is the right time yet to get into bank stocks.

Michael’s Personal Thoughts:

After four consecutive streaks of contracting economic activity, the U.S. economy grew by 3.5% in the third quarter, according to the U.S. Commerce Department. What does this mean? It means that the U.S. recession is officially over.

The U.S. now joins New Zealand, France, Russia and Germany as major economies that have exited their recessions in their latest quarters. Are we out of the woods? Of course not. With U.S. unemployment at a 26-year high just under 10% and with interest rates poised to rise globally, the economic slump is far from over. In fact, any of the countries I mentioned above could easily fall back into recession.

Where the Market Stands:

Well, it looks like we got through the dreaded stock market months of September and October unscathed. The Dow Jones Industrial Average started September at 9,450. This morning, the Dow Jones opens at 9,962, a gain of 512 in two months. Back in August, I began reading and hearing many analysts warning us of the “bad” September and October months. As usual, the market delivered the opposite. The Dow Jones sits today 13.5% higher than it started 2009.

What He Said:

“Even the most novice investor can now read the chart of the Dow Jones U.S. Home Construction Index and see that it is trading at its lowest level in five years. If, like me, you believe that stocks are an indication of what lies ahead, this important index is telling us housing prices are headed to 2002 levels! What would that do to the economy? Such an event would devastate the U.S.” Michael Lombardi in PROFIT CONFIDENTIAL, December 4, 2007. That devastation started happening the first quarter of 2008.