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This blog post originally appeared on RealMoney Silver on May 7 at 7:57 a.m. EDT.

After wallowing at ridiculously cheap levels, the financial sector has been on a recent ride, which is reminiscent of the party in technology stocks 10 years ago.

Back two months ago, investors, preoccupied by the toxic assets that infected the balance sheets and capital in the world's financial institutions, ignored the value of banking franchises which possessed, at their core, a stable and low-cost deposit base.

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Today, investors, preoccupied by the extraordinary reversal in price momentum, are doing the opposite -- that is, buying up the sector in Internet time as if the major money center banks are the reincarnation of late-1990s market leaders









The proximate cause for the remarkable ramp this week is investors' optimism that the stress test and its recommendations will be the final chapter (and an exclamation point!) to improving the stead of the industry's capital inadequacy. The general view seems to be that there will be smooth sailing after a final meal at the capital trough in the weeks ahead.

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I am less optimistic.

The overshoot to the downside through early March has now morphed into a frenzied buying stampede and pricing disequilibrium that, as expressed below, is ignoring the damage to the banking industry's balance sheets, a continuing negative loan-loss cycle and the reduced earnings power of the industry.

  • A series of dilutive capital raises has served (and in the future will likely continue to serve) to reduce the earnings power of many financial institutions, both from the standpoint of higher interest expenses and more shares outstanding.
  • Many financial institutions have jettisoned profitable businesses in order to replace the lost capital from the drain of toxic assets, serving to permanently cripple earnings power.
  • While there has been second derivative improvement, there is growing evidence that the consumer loan-loss cycle will weigh on banking profits for years to come.
  • The commercial or nonresidential real estate downturn is only beginning to be felt on banking industry profits; it, too, will be a drag on earnings for several more years.
  • Forward earnings power will be limited, owing to government restrictions on a reduced ability to lever up capital bases as well as a more moribund capital market in 2009-2011 (vis-à-vis the early 2000s).
  • The banking industry, more than nearly any other market sector, is exposed to a possible double-dip in the U.S. economy in late 2009-early 2010.
  • Even if the economy does not double-dip, my baseline expectation of an uneven, lumpy and inconsistent economy over the next three years will prove hard for the financial industry to navigate in.

From my perch, investors should sober up and reduce their holdings in financials now. Financial stocks are now priced to perfection.

Doug Kass writes daily for

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Know what you own: Some financial stocks of note include JPMorgan Chase (JPM) , Wells Fargo (WFC) , Citigroup (C) , Bank of America (BAC) and Bank of New York Mellon (BK) .

At the time of publication, Kass and/or his funds had no positions in the stocks mentioned, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Long/Short LP.