Investing in Financial Stocks: Is Now the Time to Bank on C, COF, BAC or JPM?

Based on recent performance from the sector's biggest names, it's easy to argue that financial stocks are making a comeback.

Capital One Financial Corp. (NYSE: COF) is up 27% in 2012. Citigroup Inc. (NYSE: C) is up 29%. Bank of America Corp. (NYSE: BAC) is up a whopping 59%.

Indeed, a survey of 184 analysts conducted by Bloomberg News in January expected bank profits to rise 57% in 2012.

"The banks could get some positive operating leverage in 2012 from trading normalizing and expenses normalizing," Chris Kotowski, an Oppenheimer & Co. (NYSE: OPY) analyst, told Bloomberg.

Kotowski expects an 18% earnings-per-share increase for each of the six major investment banks.

But guess what? A year ago that same survey of analysts predicted profits would climb 32% in 2011.

Instead, financial stocks were the worst performers among 10 industries tracked within the Standard & Poor's 500 Index.

So far in 2012, however, financial stocks are the second leading sector in the S&P 500 with an 18% gain. That compares to an 11% gain by the broader market.

In short, whether you are looking at Goldman Sachs Group Inc. (NYSE: GS) or the entire financial sector, last year's losers have suddenly become this year's winners.

So is it time to take some chips off the table, or is now the time to double down for the long term?

Uncertainty for Financial Stocks

Financial stocks are performing much better this year as fears over the European debt crisis have subsided and investors are seeing signs of a U.S. economic recovery.

But political uncertainty surrounds the industry.

At the core of most concerns is the push from governments around the globe for more regulatory reform.

Safeguards requiring higher levels of capital reserves under the "Basel 2" and "Basel 3" rules will force financial institutions to keep larger amounts of cash on hand. That will prevent them from leveraging capital by lending or investing money to grow profits.

The other concern for U.S. banks revolves around the so-called "Volcker Rule," with its ban on trading the markets with house money.

Consider that BofA's Global Banking and Markets group raked in a profit of $3.2 billion in the first quarter of 2010 from its trading operations. If the Volcker Rule were strictly enforced, those profits would simply vanish.

On the other hand, the Federal Reserve's easy money policy has allowed big financial firms to borrow money from the government at extremely favorable rates. In turn, financial firms have been purchasing government bonds and profiting from the spread.

Since the Fed has vowed to keep the funds rate at or near zero until 2014, they should continue to profit.

Also, banks hurt by foreclosures could get a significant boost from the new and improved version of the Home Affordable Refinance Program (HARP 2.0). Under the new rules, large banks would no longer be subject to "putbacks" for refinanced loans that weren't properly vetted.

"Under HARP 2.0, if a borrower's mortgage is guaranteed by Fannie Mae or Freddie Mac, [the banks] are in like Flynn," Money Morning Capital Waves Strategist Shah Gilani wrote in a recent Wall Street Insights & Indictments column.

Financial Stocks Are Not All the Same

But results from the Fed's latest "stress test" shows there are huge differences between the financial firms.

Although the central bank said that 15 of the 19 largest financial firms had enough capital to withstand a severe recession, several barely squeaked by.

But at least one big name passed with flying colors.

At the top sits JPMorgan Chase & Co. (NYSE: JPM), which has managed to navigate through the mortgage mess almost unscathed. In fact, the company recently announced plans to increase its quarterly dividend by 20% and buy back $15 billion of its shares.

On the other hand, BofA didn't even bother to ask the Fed for permission to increase its dividend this year after being denied in 2011.

And Citigroup didn't meet the "Tier 1" capital requirement - a reserve fund which would serve as a backstop against further market instability.

The stress tests are an example of why you should choose carefully when investing in the financial sector. Besides JPMorgan, there are other stocks to consider.

BB&T Corp. (NYSE: BBT) raised its dividend this year and saw second-quarter profit increase 20% over the same period last year.

But you should know there are 81 members of the S&P financial sector - and many are solid companies that have little exposure to the banking business.

Symetra Financial Corp. (NYSE: SYA) an insurance and pension fund manager, is up 22% this year and pays a dividend of 2.4%.

Shares of Federated Investors Inc. (NYSE: FII), an asset management firm, have gained nearly 40% this year.

But with the recent run-up in prices, the Financial Select Sector SPDR ETF (NYSEArca: XLF), gives you broad exposure to both the banks and non-banks, and is probably the safest bet.

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