Five Things You Need to See Before Buying Bank Stocks

Financial-services shares are in the dumps, but you should look for these signs before expecting a rally.
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Bank stocks have made so many false recoveries over the past year that an increasing number of investors have given up expecting a real one. That'd be a mistake, since the five ingredients needed for a lasting rally could be in the offing.

Bank stocks have made several efforts to climb back to the highs posted last April. Six attempts of varying intensity have failed, even though banks are operating in what is meant to be the perfect economic environment of good growth without inflation.

In fact, bank stocks are now close to the bombed-out levels they sank to during the severe financial markets turbulence of 1998's third quarter, according to the

KBW Banks Index

. This yardstick is now 29% off its 1999 peak.

As a result, investors in financial stocks now look at their sector with despondency, with few willing to stick their necks out and predict a recovery after so many fizzled rallies. But recoveries don't just come out of the blue; they need definite causes. And there are five things that have to happen -- probably not all at once -- before financial stocks go up, and stay up.

1. All Fed Up

By far the biggest factor weighing on bank stocks is the fear that the

Fed

is going to continue raising interest rates to keep the economy from growing too fast and sparking inflation. Higher rates hurt banks because they reduce demand for loans and increase banks' own borrowing costs. And if higher rates actually cause the economy to slow markedly, a large number of borrowers can default on their loans, forcing banks to subtract such losses from profits.

"The No. 1 thing that has to happen for there to be a sustained rally is for investors to see an end to the Fed tightening," says Andrew Dinnhaupt, manager of the

(PREAX) - Get Report

Paine Webber Financial Services fund. Dinnhaupt expects bank stocks to start ascending two to three months before the end of this tightening phase. If, as many in the market believe, the Fed intends to raise rates two or three more times, its tightening will have come to an end as early as its June 27-28 meeting. Feasibly, therefore, a rally could start around April or May, according to Dinnhaupt's theory.

2. Deals and Deal Makers

Some observers think some high-profile acquisitions could help stir up a rally in the financial-services sector. "A couple of big mergers could move the group," says Adam Levy, an analyst for the

(FSFSX)

Invesco Financial fund. But the deals would have to be convincing for the market to receive them well since recent takeovers have actually caused the buyers' stocks to dip.

Flurry of False Starts
The KBW Bank Index's rocky road down

Source: Baseline

Currently, the market thinks only a handful of banks could do mergers well. Among the large-cap banks, they are:

Citigroup

(C) - Get Report

,

Chase

(CMB)

,

Wells Fargo

(WFC) - Get Report

,

Fifth Third

(FITB) - Get Report

,

Fleet Boston

(FBF)

and

Firstar

(FSR)

.

While possible predators are few and far between, victims are plentiful. Problems at a number of large banks have knocked their prices right down and made them cheap-looking to stronger institutions. Among the fallen are

Bank One

(ONE) - Get Report

,

First Union

(FTU)

,

U.S. Bancorp

(USB) - Get Report

,

KeyCorp

(KEY) - Get Report

and

National City

(NCC)

. Their stock prices are off some 50% since the beginning of 1999.

3. Turnaround Talk

Sentiment toward bank stocks could improve if a dramatic turnaround occurs at a large institution that was responsible from turning investors off the sector in the first place. A small but growing number of analysts think First Union, after a series of disappointments, could start to pleasantly surprise investors. A

Lehman Brothers

bank analyst, for example, upgraded First Union from neutral to outperform Wednesday. (Lehman has done no recent investment banking work for First Union.)

Still, an unexpected early recovery at any of the underperformers could easily be overshadowed by negative announcements from other large banks.

Bank of America

(BAC) - Get Report

, the nation's second-largest institution, remains a worry to some. Like the five laggards listed above, Bank of America's expected earnings power has fallen short, yet, unlike the others, it has not formally revised down its profits outlook in a special press release. Tom Brown, head of

Bankstocks.com

, a New York-based Web site that focuses on shares in financial institutions, points out that Bank of America's 1999 earnings were 18% below the target set in 1998 when

NationsBank

merged with

BankAmerica

. (Bankstocks.com has no position in Bank of America, nor does Brown's money-management firm

Second Curve

.)

4. Take This, Tech

A reversal in tech stocks could also help bank stocks get back on their feet. First, if the tech-dominated

Nasdaq

index comes down or flattens out, the Fed will be less likely to raise interest rates. Also, many funds have been selling bank stocks and putting the proceeds into better-performing tech companies in a bid to keep up with benchmark indices. And fund investors have been redeeming money from bank stock funds, which forces these funds to sell their holdings to raise cash. For example, estimated net outflows from financial sector funds totaled $5.7 billion in 1999, equivalent to nearly 30% of the $19.6 billion in assets in this group at the start of last year, according to the Boston-based

Financial Research Corporation

. If tech suffers a big setback, these huge money flows out of financials could reverse with a huge impact.

5. New World Order

If the boom in tech stocks continues, then banks may come back in favor if they convince investors they are embracing the New Economy, says Lanny Thorndike, a manager on the

(CENSX)

Century Shares Trust. He says Chase is moving in this direction with its

acquisition last year of

Hambrecht & Quist

and its booming venture capital operation. (Thorndike's fund holds Chase shares.) And Wells Fargo is also attempting this shift with its big push into Internet banking.

As originally published, this story contained an error. Please see

Corrections and Clarifications.