Why Bank Stocks Are Such a Drag

By Anthony Mirhaydari of Investor Place

One of the stock market's most important sectors has failed to confirm the push to new highs, and that spells trouble for equities in general.

In late August, when it looked as through the sky was falling -- with stocks plunging and the global economic recovery stalling -- to the surprise of many, bank stocks started perking up. That helped turn things around for the broad market, since financial stocks have the heaviest weighting of all sector groups in the all-important S&P 500 benchmark.

But since then, the financials have lagged badly. The Financial SPDR ( XLF) is essentially unchanged since Sept. 3, while the S&P 500 is up nearly 4%. Regional banks have been particularly weak, with the Regional Banking SPDR ( KRE) trapped in a pervasive downtrend from the April high. Unlike the broad market, the KRE continues to set a pattern of lower highs and lower lows.

There are a number of reasons for the lack of buying interest in bank stocks in general and regional bank issues in particular.

The first is that loan growth has been weak as banks tightened credit standards and businesses stocked up cash reserves instead of taking out new credit. This weighs on earnings, since bankers have no alternative but to put cash into low-yielding U.S. Treasury bonds. Credit Suisse analysts believe U.S. banks could experience another three quarters of this malaise before loan growth bounces back.

The second problem is margin pressure as the difference between short-term and long-term interest rates narrow. This is known as the "net interest margin" since banks borrow for the short-term and lend for the long-term. As the margin narrows, bank earnings take a hit.

The third problem is increased regulation. From the Dodd-Frank bill enacted in July, we get the creation of the Consumer Financial Protection Bureau. The likely impact will be a reduction in fee income, which will be hard to offset with other sources of revenue. Banks love fee income because it doesn't expose the bank to additional interest rate risk. Overall, Credit Suisse estimates that regional banks could see a 13% hit to earnings per share due to regulatory changes.

And until these factors change, or are adequately priced into the sector, bank stocks will continue to act as dead weight on the broad market.

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