What to do With Bank Stocks?

A number of the accounts that I manage compare their results versus the S&P 500.

"Beating the benchmark" for these accounts is obviously important for lots of reasons. Consequently, I tend to spend a considerable amount of time studying where I have placed the "bets" in the portfolios.

One of the areas that I am struggling with in the financial sector.

It's hard to believe, but it was only two years ago that the financial group as a whole, and bank stocks in particular, were very close to a complete meltdown. Only strong government intervention prevented utter chaos.

Now many bank executives - including JP Morgan's Dimon and Barclay's Diamond - have essentially declared that the crisis is over, and the future for the banking sector is now rosy.

Recently released bank earnings have been for the most part pretty encouraging. For example, even though the market was generally disappointed by Citigroup's earnings report yesterday, the fourth quarter of 2010 marked the fourth consecutive quarterly profit for the big banking conglomerate.

And yet I still can't believe that the "all clear" is in place for the sector.

This morning's Financial Times had a short piece that summarizes a lot of my concerns; here's an excerpt:

Borrowing costs have been at rock bottom for so long that this fact is almost forgotten. Sure, it looks good that JP Morgan's non-performing loans for the fourth quarter fell another 4 per cent. But a firm-wide run rate of $15 billion is still at mid-2009 levels, which itself is two-thirds higher than a year before that. With a monetary policy backdrop that could not have been more generous to struggling companies and consumers, such a small decline in NPLs is hardly comforting. On the contrary, it is terrifying.

Banks have been holding onto their loans either nonperforming or in default longer than in previous credit cycles. This allows them to avoid having to recognize losses.

In addition, banks have so much much liquidity that loan repayments are actually more of a cause for concern than happiness, since loan growth is so anemic. Put another way, many banks have no use for the funds from either the Fed or a repaid loan, so they would rather a borrower continue to pay even a reduced rate of interest.

That said, bankers seem to be partying like, well, good times have returned.

Bonuses have returned with a vengeance to Wall Street as well. Indeed, CEO Bob Diamond of Barclays essentially told British regulators last week that they should just get over it; bank bonuses need to be paid to retain valued employees, so stop hounding him about the matter.

(Ah, those pesky regulators!).

Anemic loan growth; unrecognized loan losses; low interest rates; and possible "irrational exuberance" about future prospects - all should add up to a group that should be avoided.

And yet the financial sector has been on a tear over the last few months, boosting the returns of the S&P. Bank stocks in particular outperformed the market in December by 800 basis points. Woe to the equity manager that is either underweight or avoids the group.

So now my colleagues and I have to figure out what to do.