Five Reasons to Steer Clear of Bank Stocks

NEW YORK ( TheStreet) -- The largest U.S. banks have had a strong run of late with the SPDR KBW Bank ETF ( KBE) roughly doubling in the past year. We've pulled together five reasons to be cautious about their prospects from here.

1) Second Foreclosure Wave:

Roughly five to seven million home owners are technically in default, but have not yet been foreclosed upon, according to a report last week from The Washington Post .

Most of the most worrisome exposure to troubled U.S. mortgages lies with government-sponsored lenders like Fannie Mae ( FNM)and Freddie Mac ( FNM), according to a report from Oppenheimer & Co. analyst Chris Kotowski, who describes home lending as "the biggest single threat to our generally positive view of the banking industry" in a recent note to clients.

If the fragile economic recovery doesn't cooperate, and it turns out loan losses haven't quite peaked, the usual big bank suspects -- Bank of America ( BAC), Citigroup ( C), Goldman Sachs ( GS), JPMorgan Chase ( JPM), Morgan Stanley ( MS), and Wells Fargo ( WFC) (and the rest of the market) -- could be in for another round of pain.

2) Government Stimulus Removal:

The Federal Reserve has pumped $1.25 trillion into the U.S. mortgage market -- effectively by buying debt obligations of Fannie Mae and Freddie Mac, and by purchasing mortgages they underwrote. As the chart above shows, this massive intervention stabilized mortgage markets after it was announced in November 2008.

But the Fed's program is set to end this month, and it remains to be seen whether private lenders will pick up the slack.

There is also the question of how well the markets will digest eventual short-term interest rate hikes. Mike Cosgrove, principal at research firm Econoclast, expects a 50 to 75 basis point increase in the Fed funds rate, which he thinks the markets will be able to handle. However, many economists worry the Fed will be too slow to tighten monetary policy, which could spur inflation. Banks would likely perform poorly in such an environment, as the loans on their books would drop in value.

3) Regulatory Threats Resurface:

Bank stocks came under pressure in January as President Obama revealed tough new proposals that seemed to threaten the very existence of the largest of the breed. Reform legislation hadn't made much headway since then but this week's draft of a comprehensive bill by Senate Banking Chairman Christopher Dodd (D., Conn) pictured above could lead to the effort picking up some steam.

Dodd's bill, dubbed the Restoring American Financial Stability Act of 2010 would not break up big banks outright, and it does appear to allow more wiggle room on areas such as derivatives and consumer protection than many in the banking industry had feared might come down from Capitol Hill.

But the bill still does share some philosophical DNA with the so-called Volcker rule designed to limit proprietary trading that spooked many bank investors back in January, and if passed in its current form, it would increase government supervision and powers.

The wild card is the mid-term elections in November. If the Democrats fare poorly, they may decide to redouble their efforts to get tough on banks, as President Obama did after Republicans stunned the country by winning the Massachusetts Senate seat vacated by the late Ted Kennedy.

4) Recovery Already Priced In:

Since bottoming out in March 2009, the big banks have staged a historic rally with the six stocks in the chart above rising an average of more than 200% from their respective lows on a simple percentage basis. Some of that appreciation is a product of the extreme level of fear pervading the markets back then. It is also reflects the payback of bailout funds, declines in loan losses, and even a few stray profitable quarters here and there. Of late, the group has gotten a lift from news of investments by big name investors like Bruce Berkowitz, John Paulson and George Soros, and rallied along with the broad stock market.

But as the chart above shows, the stocks for the most part flattened out quite a bit once they bounced back. At current levels, the largest banks may still look fairly cheap versus next year's earnings estimates, yet they are significantly more expensive on a price-to-book basis than has been the average over the past five years. Citigroup's average price-to-book valuation over the past five years, for example, is 0.47, while it now trades at 0.76 times book value, according to Bloomberg data. A similar relationship can be seen in the valuations of JPMorgan, Bank of America, Wells Fargo, Goldman Sachs and Morgan Stanley.

While many threatened rule changes appear unlikely to stick, one exception is the requirement that banks hold more capital to insure against future losses. That will hurt returns in the sector. Investors should also note that investors like Soros and Paulson built up their big positions in Bank of America and Citigroup months ago, and may already be scaling back. The gains so far in 2010, especially respective increases of 13% for Bank of America, 22% for Citigroup and 12% for Wells Fargo, also could suggest investors getting in now may be late to the party.

5) European Contagion:

First-quarter results slated to show up next month will tell the tale but Rochdale Securities analyst Dick Bove told at the start of the month that the Greek debt crisis (Greek Finance Minister George Papaconstantinou is pictured above) may hurt trading results for many big banks in January.

The issue appears to be under control for now, but many observers believe the threat to the Euro will not go away for some time. And why should it? Stronger countries that use the Euro resent having to subsidize weaker ones, but the weaker ones will not submit to the necessary belt tightening.

While the threat of a renewed European crisis does not look severe from a U.S. standpoint, it may be enough to cause a temporary sell-off on this side of the Atlantic, providing a more attractive entry point than there is now, after a big rally.

-- Written by Dan Freed in New York

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