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Five Reasons to Love Bank Stocks

Bank stocks have come down sharply from their highs. Here's why the pessimism may be overdone.



) -- I was practically all alone on March 18 when I gave you five reasons to steer clear of

bank stocks

, but it turns out heeding that advice would not have been such a bad idea.



(KBE) - Get SPDR S&P Bank ETF Report

, which counts


(C) - Get Citigroup Inc. Report


Bank of America

(BAC) - Get Bank of America Corp Report


Wells Fargo

(WFC) - Get Wells Fargo & Company Report

JPMorgan Chase

(JPM) - Get JPMorgan Chase & Co. (JPM) Report


US Bancorp

(USB) - Get U.S. Bancorp Report

as its top five holdings, was at $26.01 when I wrote my story.

While it would hit a high of $29.22 on April 21, it touched a recent low at $23.33 Tuesday. Two reasons I highlighted, "Regulatory Threats Resurface" and "European Contagion," look especially smart. So give me an A for insight and a C+ for timing.

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Now that everyone is freaking out about bank stocks, it may be worth taking another look at the sector, which for current purposes also includes

Goldman Sachs

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Morgan Stanley

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. They have been a big part of the recent selloff, and they may have more in common with JPMorgan, Bank of America and Citigroup than any of those three does with Wells Fargo, or certainly US Bancorp.

There are plenty of reasons to be a bull on banks. Here are a few.

5. The U.S. Economy Is Improving

The recent selloff, not just in bank stocks but in global equities, has had nothing to do with any signals in the U.S. economy. It's been all about European countries like Greece, Spain, Ireland and Portugal struggling under heavy debt loads, with a pinch of fear about overzealous regulators thrown in. There may also just be a general fear that equities have come too far too fast and those things provided an excuse for selling.

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Meanwhile, things in the U.S. continue to mend. Since hitting a high of 10.6% in January, the U.S. unemployment rate is down to 9.5%. The steep rise in the chart shown here demonstrates that we've already had a historic rise in layoffs and hiring freezes. Employers freaked out, now they are hiring again, and it's hard to think of any single thing that could be more bullish for bank stocks. Sometimes it pays to keep it simple.

4. Regulatory Fears Are Overblown

Probably the biggest surprise about the regulatory reform legislation that passed the Senate earlier this month was a provision sponsored by

Blanche Lincoln

(D., Ark.) that would force banks to spin off their derivatives businesses.

Derivatives are a huge profit center for banks like Goldman Sachs, Morgan Stanley and JPMorgan Chase. It is not entirely clear whether the Senate legislation would eliminate their ability to trade, sell and design derivatives altogether, or merely sharply curtail those activities. In any case, the result would be disastrous, and a JPMorgan report Thursday estimates the Lincoln provision would halve the 2011 return on equity for Morgan Stanley and Goldman Sachs.

Even that dire prediction may be too sanguine. One former

Federal Reserve

official I spoke with fears the provision would make it impossible for banks to hedge their mortgage portfolios, which would create big problems for home lending in the U.S. It also could raise questions about the ability of multinational corporations in a wide range of industries to hedge against commodity and currency risks.

Many of these fears are, to an extent, priced into stocks, and into bank stocks in particular. If the Lincoln provision becomes law, the stocks will trade down further, but if the impact is really so dire as to shut off home lending, or keep


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from doing business around the globe, Congress will be forced to fix it. More likely, though, is that the provision never becomes law.


White House

downplays it and House Financial Services Committee Chairman

Barney Frank

(D., Mass.) doesn't seem to like it much. Fed Chairman

Ben Bernanke

has also opposed it. Lawmakers are essentially just working out a way to kill it without seeming like they are sucking up to the banks. They will find it eventually, and when they do, bank stocks will rally.

3. Low Tax Bills Ahead

As the accompanying graphic shows, many banks won't be paying taxes for a year or, in some cases, many years. That is especially true for banks that lost a lot of money during the crisis, which is to say, nearly every bank! All the potential write-offs mean yesterday's losers reap big savings when they become profitable again, and few industries lost more money than banking in recent years.

Looking at a term called net deferred tax assets is a good way to figure out how much in losses and other items companies can apply toward reducing their tax bills in the future, according to corporate tax consultant Robert Willens. Though banks already count this number as an asset that is reflected in book value, Willens nonetheless believes the issue is poorly understood and may not be fully reflected in companies' share prices.

Not reflected in book value is something called a valuation allowance. That refers to losses banks aren't counting as an asset because accounting rules require them to demonstrate a better than 50% probability they will be able to earn enough to use the loss as a write-off. If earnings prove stronger than expected, banks can release capital they have to hold against that valuation allowance, leading to a rise in book value.

2. Worries About Europe Are Excessive

Fiscally stronger European countries like Germany have made a major commitment to support weaker ones like Greece. This is not a small thing, and it will go a long way to providing stability on the continent. Longer term, you may see some weaker countries drop out of the euro, but that's at least a couple of years off.

For all their size, even the largest U.S. banks like Wells Fargo, JPMorgan and Bank of America have essentially no European exposure when it comes to retail businesses, like credit cards or mortgage lending. Wealth management and business lending is minuscule. Even investment banking and business lending operations pale in comparison to the size of their counterparts in the U.S. and other parts of the world. Even Citigroup, traditionally the most global of large U.S. banks, is far from a major player in Europe.

1. Everyone Is Selling

Though bank stocks, like the rest of the market, have showed some signs of life this week, fear has clearly injected itself into the market. The mantra of Sage of Omaha Warren Buffett that it pays to be greedy when others are fearful and fearful when others are greedy proves itself time and again. The trick, of course, is knowing whether people are going to get more fearful before they start to get greedy again. You can never know for sure, which is why you simply have to add risk compared to where you were when the market was higher a month ago.

The SPDR KBW Bank ETF has roughly matched the Dow Jones Industrial Average in the selloff of the past month, but it has sharply outperformed the Dow since markets rebounded off their lows in March 2009. When the markets resume their climb, bank stocks are sure to outperform.


Written by Dan Freed in New York