I recognize that there is a body of market participants who worship at the altar of price momentum.Sometimes, however, when traders and investors blindly follow charts from the lower left to the upper right (hat tip Sir Denny Gartman!), those late to the party get burned, as has been the case recently with the biotech sector. This brings me to the current infatuation with and rotation into money center bank stocks. I own only two bank stocks: Citigroup ( C) and Northwest Bancshares ( NWBI). Though the financial sector has recently perked up, one has to question the piling on. I have spent my life following the financial sector -- I understand the group's profit dynamics. I coauthored the book Citibank with Ralph Nader and his Center for the Study of Responsive Law in the early 1970s. And a few years later, while I was working for "The Chief" at Putnam Management in Boston, I spent five solid years researching the sector. (During that period, I was voted the No. 1 buy-side banking/thrift industry analyst by Institutional Investor.) Banking industry profits are basically a function of several basic variables: the level of loan demand, FICC activity (i.e., trading in products tied to interest rates, corporate credit, mortgages, currencies and commodities), the trend in credit quality, interest rates and the slope of the yield curve. Loan demand remains tepid, growing slowly. In part, this is a function of subpar economic growth, pressures (regulatory and expenses) on small businesses and the liquid state of the country's largest companies (which also have access to cheaper, public money). FICC activity has contracted and has turned from being a tailwind to being a drag on bank industry profits. Credit quality has been improving for three to four years. Loan-loss provisions have been consistently declining (and reserve releases have expanded), acting as less of a headwind to banking industry profitability in recent years. But the benefit of those non-operating factors is beginning to diminish now and will be less of a tailwind in 2014-2015. Which leaves us to interest rates and the slope of the yield curve. This is the most important profit contributor and should be the most worrisome area for bank investors and bank profits, because it will likely put a limit on any improvement in net interest income (and margins).
This column originally appeared on Real Money Pro at 8:40 a.m. EDT on March 25.