We Warned You Not to Buy Bank Stocks - And Here's Why

If you weren't convinced before, hopefully you've seen the light now: Don't buy bank stocks.

Money Morning Global Investing Strategist Martin Hutchinson first warned it was time to bail on bank stocks on Aug. 17. He said the sector was headed for a "catastrophic decline."

"Margins are narrowing, government regulation is increasing, and the outlook for big deals is drying up," said Hutchinson. "In other words: The risks related to bank stocks are as present as they ever were - just the profitability is missing."

Hutchinson was right on with his call. Anyone who heeded his warning saved themselves from the losses U.S. banks have since sustained.

Share prices for many big U.S. banks tumbled in the period between the publication of Hutchinson's article and yesterday's (Wednesday's) market close. Bank of America Corp. (NYSE: BAC) lost 11.6%, Goldman Sachs Group Inc. (NYSE: GS) fell 9.3%, JPMorgan Chase & Co. (NYSE: JPM) 6.5%, and Morgan Stanley (NYSE: MS) 2.2%.

The Standard & Poor's Financials Sector Index now is down more than 18% for the year. Global bank stocks have hit their lowest valuation in 40 years.

And this industry's stock losses are just the beginning of the price pain.

Poor Earnings Reflect Banks' Struggle

Hutchinson pointed to key factors that would weigh on bank profits, like trading losses, decreased lending, and the overhang of dead mortgages.

This season's dismal bank earnings have supported Hutchinson's forecast.

Goldman Sachs posted its second quarterly loss since going public in 1999. Quarterly revenue fell 60% from last year's third quarter to $3.59 billion. Investment banking revenue was down 33% from last year, and fixed income, currency and commodities client trading business fell 36%.

JPMorgan on Oct. 13 released earnings that beat analysts' estimates, but disappointed with signals of weakness in the company's core business. Equity market sales fell 15%, fixed-income revenue 14%, and investment banking revenue 13%.

JPMorgan Chief Executive Officer Jamie Dimon couldn't reassure investors that things would improve down the road.

"It's hard not to be cautious," Dimon said on a conference call earlier this month. "Right now, nobody knows what is going to happen tomorrow."

Citigroup Inc. (NYSE: C) and Wells Fargo & Co. (NYSE: WFC) both cited mortgage losses as reasons overall revenue fell last quarter. Citigroup lost 8% in overall revenue from last year's third quarter, and Well Fargo lost 6%. The banks saw a rise in delinquencies of more than 90 days in mortgage and credit card payments, and - just as Hutchinson predicted - expect the trend will increasingly hurt profits in future quarters.

"The residential mortgage problems are unprecedented," Gerard Cassidy, an analyst with RBC Capital, told The Financial Times. "The rate of improvement in the delinquencies has slowed down dramatically in the last two years and even over the more recent quarters."

A big mortgage portfolio also means billions of dollars of legal claims. Bank of America reported $11.7 billion worth of pending claims from investors who want the bank to buy back bad mortgages - which could take years to settle.

Banks also suffered losses from the dried up lending business. Corporations are turned off from racking up debt and prefer using cash reserves instead of bank financing. Consumers also have made strides trimming their debt load, which means less money for credit card issuers. Bank of America's credit card division lost 16% of its revenue last quarter.

While Morgan Stanley posted higher profit than expected, it was due more to sleight of hand than successful operations. As Money Morning Capital Wave Strategist Shah Gilani explained last week, accounting "tricks" can make earnings appear better than the banks actually performed. Morgan Stanley lowered the value of its debt by using "debt valuation adjustment" bookkeeping, resulting in $3.4 billion more in revenue.

Bank of America used the same move to offset its operating losses last quarter.

Don't let the accounting maneuvers fool you - they don't erase banks' underlying problems, evidenced by more job cut announcements from the sector. Bank of America plans to cut 30,000 jobs, Goldman will lay off 1,000, and Morgan Stanley said it would shed 300 "underperfoming financial advisors."

The Only Options for Bank Stocks

We've told you that record-low prices for solid companies can present great buying opportunities - but that is not the case for bank stocks. The sector's risks are too heavy and long-term.

But for eager investors there is a way to profit from the sector's dismal outlook. Gilani said that while bank stocks are no longer safe investments, they do provide trading opportunities.

Just don't buy any right now.

"Now, for the foreseeable future, the only way to play banks and financials is by trading them," said Gilani. "Banks face so many issues, both in the near term and on a long-term secular basis, that putting shares away, even now when they look cheap, could be hazardous to your wealth and your mental state."

Gilani - along with Money Morning Chief Investmest Strategist Keith Fitz-Gerald - recommends investors consider shorting banks. Fitz-Gerald said any rally in bank stocks would be tied to hopes of a European resolution, and will open the door to profit from short trades.

Gilani also suggests buying puts at least three months out. If you do trade bank stocks, don't be hesitant to take your gains fast, and always limit your losses to what you can afford.

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